Private investment managers are now evaluated based on their internal rate of return (IRR), but all investors need to be mindful of the severe disadvantages of this metric. The annualized return statistic captures the compounding of money over time, while IRR does not. Many investors make the expensive error of comparing IRR to annualized returns when making investing choices. Investors must grasp how IRR varies from annual returns to make more intelligent real estate investment selections.
Annualized return is the amount of money investment has earned or is expected to earn annually. After accounting for compounding, a $1 million investment yielding a yearly return of 8% will be worth more than $10 million after 30 years.
On the other hand, IRR seeks to provide investors with the same annualized rate of return while considering the timing of cash flows, even if money is invested for brief periods such as days. IRR also expects that all dividends will be reinvested promptly, a compounding assumption that is not met in practice.
The primary difficulty with IRR is that it does not quantify how much money you have earned. Unlike the quantified annualized return example above, we do not know the current value of a $1 million investment that yields an IRR of 8% over 30 years.
Considering a $100,000 investment over three years, the following illustration demonstrates the limits of IRR:
| Initial Expenditure | $(100,000) |
| Flow of Funds in Year One | + $50,000 |
| Flow of Funds in Year Two | + $50,000 |
| Funds flow in the third year | + $20,000 |
| Gain on Equity Total | $20,000 |
The real IRR for this investment over three years is 11.2%. Simply enter the cash flows into Excel and use the “=IRR” tool to compute this. To calculate the IRR of an investment, the formula applies merely a discount rate to the investment’s cash flows. Essential here is that the return on investment was just $20,000, or 20 percent.
The investment would need to yield 6.3 percent to earn the same yearly total return. In other words, if you had invested $100,000 in an asset that returned 6.3% yearly, it would be worth $120,000 three years later.
If the $100,000 had risen at a yearly rate of 11.2%, the gain would have been closer to $37,000. Before investing in a private equity fund that achieved a 20% annual IRR, ascertains how much real wealth was generated by calculating the total return on invested capital, or multiple.
To better highlight the distinction between IRR and annualized returns, I will analyze two $100,000 investments that both earn a 15% IRR but provide vastly different yields.
| Scenario #1: | |
| Initial Expenditure | $(100,000) |
| Flow of Funds in Year One | + $50,000 |
| Flow of Funds in Year Two | + $50,000 |
| Funds flow in the third year | + $28,500 |
| Gain on Equity Total | $28,500 |
| Scenario #2: | |
| Initial Expenditure | $(100,000) |
| Flow of Funds in Year One | + 0 |
| Flow of Funds in Year Two | + 0 |
| Funds flow in the third year | + $152,000 |
| Gain on Equity Total | $52,000 |
The first example generated a total return of 28.5%, whereas the second generated a total return of 52.5%. This illustration demonstrates why evaluating two investment options using IRR alone may be expensive. Both investors locked their funds up for three years, but only one realized a substantial profit. Because all of the cash flow occurs at the end of Scenario #2, the 15% IRR is comparable to a 15% yearly return. The $100,000 investment is effectively growing at 15 percent each year.
To IRR, receiving money sooner rather than later is preferable and unquestionably helps reduce risk. In general, cash flows that occur in the far future are riskier than anticipated.
In scenario 1, the investor would immediately put any cash flow received into other assets. You do not know, however, what investments will be accessible in the future, and, likely, these investments may not provide the same IRR. Additionally, it requires time, effort, and self-discipline to choose an appropriate location to reinvest these payouts.
It should now be clear that IRR and annualized returns seem comparable; they are entirely distinct measurements. The pursuit of high IRR over short periods is one of the most common errors made by investors. A private real estate manager who generates a high IRR may not cause actual wealth, so one must also consider total return and multiple on equity.
Occasionally, it is preferable to make long-term investments and let compounding do its thing. Long-term, you may be better off obtaining an annualized return of 10 percent than chasing IRRs of 20 percent. “Beware the investment activity that creates acclaim; the big movements are often met with yawns,” advises the legendary Warren Buffett.
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