03 AAS Learning Center - Real Estate Investment Terms

Internal Rate Of Return (IRR)

By Robert Prouty and Darrell Roberts

The Internal Rate of Return (IRR) is a measure of an income producing property’s average interest rate return on invested equity during the hold period.

IRR is a complicated formula and best calculated by Excel. It uses the initial equity contribution, the net cash flow for each year and the appreciation from sale at the end of the hold period to calculate the return. Similar to cash-on-cash, IRR can be calculated on a leveraged and unleveraged basis.

Example 1: Consider the cash flows from these two properties:

Property A required an initial $1,000,000 equity investment and the investor received a 10% cash-on-cash return each year. At the end of the 10-year hold period, the investor sold the property and doubled her initial investment. The IRR for this investment was 15%.

Property A
Year	Return	Cash-on-Cash
Investment	$(1,000,000.00)
1	$100,000.00	10%
2	$100,000.00	10%
3	$100,000.00	10%
4	$100,000.00	10%
5	$100,000.00	10%
6	$100,000.00	10%
7	$100,000.00	10%
8	$100,000.00	10%
9	$100,000.00	10%
10 - Sale	$2,000,000.00	200%
IRR = 15%

Property B also required an initial $1,000,000 equity investment. Unfortunately, the property struggled during the hold period and the investor received a minimal return on his investment. In fact, the total cash flows for the 9 years preceding the sale were only $25,000. Luckily, market conditions were favorable and the investor recouped his entire investment plus an additional $3,000,000. The IRR for this investment also was 15%!

Property B
Year	Return	Cash-on-Cash
Investment	$(1,000,000.00)
1	$15,000.00	2%
2	$(25,000.00)	-3%
3	$25,000.00	3%
4	$(15,000.00)	-2%
5	$(15,000.00)	-2%
6	$15,000.00	2%
7	$25,000.00	3%
8	$10,000.00	1%
9	$(10,000.00)	-1%
10 - Sale	$4,000,000.00	400%
IRR = 15%

Similar to a cash-on-cash return, IRR is a metric an investor can use to evaluate the potential return of a property (i.e. “risk”) versus an alternate investment such as a US Treasury Bond. While IRR is a good tool that takes into account a property’s eventual sale, it is not a substitute for cash-on-cash returns since IRR is not a measure of a property’s cash flow stability.

Both the iProfit Analyzer™ and the Apartment Acquisition Model™ calculate the leveraged and unleveraged IRR for an investment. IRR is based upon the equity investment and the user’s cash flow assumptions. The models calculate the return in each year of the user’s hold period.

You can change the underlying assumptions to recalculate the IRR to better understand under what circumstances the property will meet your investment criteria.

IRR is best used when evaluating development, pre-stabilized or value-add properties. In these cases, the buyer is expecting little to no cash flow from the investment with the bulk of the investment return coming upon the sale (or perhaps refinance) of the stabilized asset.

Example 2: Consider a development project. An investor contributes $3 million to a development project. During the entitlement and construction phase, there is no cash flow available to the investor. The investor will get a small distribution in Year 4 as the property stabilizes and their equity return and appreciation at the sale. The cash flows would look like this:

Property C
Year	Return	Cash-on-Cash
Investment	$(3,000,000.00)
1	$-	0%
2	$-	0%
3	$-	0%
4	$100,000.00	3%
5 - Sale	$7,500,000.00	250%
IRR = 26%

In this example, the IRR is 26% over the 5-year hold period. Is this a good return? It is worth the risk? That is based entirely upon the risk profile of the individual investor.

When evaluating the IRR of a project, an investor should consider several shortcomings:

Shortcoming #1: IRR is skewed by the final value of the project. Regardless of the strategy for the property, the buyer must develop a pro forma for the entire hold period including a final value based upon NOI and cap rate. Those assumptions can prove wildly incorrect and will increase or decrease the expected IRR.

Shortcoming #2: IRR does not reflect the stability of a property’s cash flow. As shown in Example 1, a property can have two different cash-on-cash returns yet have the same IRR depending on the sale assumptions.

Shortcoming #3: IRR can be manipulated by the property’s performance both good and bad since it will change the cash flow to the investor. Decisions during the hold period that affect the final value – such as deferred maintenance (bad) or property improvements (good) – will have a greater impact on the IRR.

Shortcoming #4: Cap rates play an important role in the final value of the property. It is impossible to predict a market cap rate years away. When investing, a buyer or investor should pay careful attention to developing a decent methodology for assuming the sales cap rate as that will inflate or deflate the expected IRR.

It should be noted that most IRR calculations are quoted before tax. The main reason is that each investor’s tax situation is unique. An investor should use IRR as just one of several metrics in evaluating a specific property for purchase.

The principals of Apartment Analytics Software have extensive experience in determining a property’s cash flow. If you are looking for assistance or have questions about IRR, please contact us at www.ApartmentAnalyticsSoftware.com.

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Internal Rate Of Return (IRR)

By Robert Prouty and Darrell Roberts

The Internal Rate of Return (IRR) is a measure of an income producing property’s average interest rate return on invested equity during the hold period.

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