Internal Rate of Return (IRR)

Internal Rate of Return (IRR) is a fancy way of saying how much money am I making off this investment, and how quickly am I making it? in other words, if your investment was a race, IRR is the pace at which your money grows. It’s like asking, “For every dollar I invest, how fast can I get my money back plus some extra?” The higher the IRR, the faster your money is working for you.

Why it’s useful

IRR is the most used real estate metric because it models exactly what you most want to know: total annualized return over the period of the investment. By focusing on equity investment returns, IRR considers your assumptions about not just asset-level performance but also debt financing and eventual exit and return of capital (hopefully). Therefore, you can get a more complete sense of the opportunity’s potential and macro assumptions through IRR.

The Internal Rate of Return (IRR) is a widely used metric in real estate as it provides you with a clear view of the investment’s total annualized return over the investment period. By concentrating on equity returns, IRR incorporates your projections for asset performance, debt financing, and the eventual return of capital and exit strategy. This allows you to gain a comprehensive understanding of the investment’s overall business plan and market assumptions.

IRR requires that you make a lot of assumptions, including forward-looking projections that you don’t necessarily have a way of knowing, such as supply & demand dynamics, interest rates, and exit cap rates. For this reason, IRR is both good and bad.

Why it’s bad

Despite being one of the most commonly used metrics, IRR is flawed for two main reasons:

(1) IRR is heavily dependent on exit cap rate. This allows for investment assumptions to be easily manipulated; for example, if a deal is shy of meeting the desired return, the exit cap rate can simply be adjusted downward–implying a higher sale price in the future. Since cap rates fluctuate considerably over time, it ultimately falls on to you to assess whether the assumptions about the exit cap rate are realistic.

The IRR can be a challenging metric to rely on for evaluating an asset’s performance, especially in hindsight. Many investors who purchased multifamily properties between 2010 and 2018 often achieved strong outcomes, even when they missed their projected rents or faced unexpected expense overruns. This success was largely due to cap rate compression and favorable exit prices during that period. Ultimately, it is up to you to determine if the assumptions surrounding the exit cap rate are realistic, as these can fluctuate significantly over time.

(2) IRR incentivizes shorter holding periods.

The quicker returns are generated for you, the higher the IRR will be. For instance, some of the highest IRRs I’ve seen in real estate originated from flipping land. This is largely because these projects often have holding periods of under a year. While these deals can yield exceptionally high IRRs, they’re not always a great option because you then face the challenge of finding a new home for your funds.

What’s Next

If you’re looking to gain deeper insights into your real estate deals and ensure you’re making informed investment decisions, I’m here to help. With extensive experience in analyzing various asset classes and strategies, I can assist you in understanding the key assumptions driving your deal’s performance, identifying potential risks, and uncovering opportunities for maximizing value. Whether you’re a seasoned or just starting out, reaching out to a real estate investment expert like me can provide the clarity and guidance needed to align your investments with your financial goals.

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