The phrase “IRR” is frequently used by real estate sponsors to brag about the prospective profits of their projects. However, the majority of passive real estate investors are not completely versed in this lingo. An investment opportunity is frequently valued using the IRR measure, which is used to evaluate a deal’s internal rate of return. The IRR makes an effort to quantify the return on investment over the length of the whole holding term while taking into account probable variations in income, property value, and debt payment.
In this article, we examine the usage of IRR, its motivations, the potential for manipulation, and its suitability as a statistic for assessing passive real estate investment prospects.
What Exactly Is IRR?
Using a few indications, investors frequently evaluate transactions side by side to make sure they are comparable. One of these measures is a contract’s internal rate of return or IRR. The average return a project will offer over its holding period is the IRR, which comprises all cash flow, refinancing expenses, and disposal revenues.
IRR relies on predicting future cash flows, which necessitates some degree of an assumption given that market circumstances may change in the flick of an eye, which is one of the reasons investors find it difficult to understand (case and point: COVID-19). In addition, IRR uses a discount rate to account for those future cash flows, which is an abstract concept that depends on the time value of money. Comparatively speaking, it is a considerably more challenging measure to use (and comprehend) than other indicators like cap rates. Below, we’ll go into greater depth about how IRR and cap rates differ.
Passive Investment IRR Calculation
As previously said, computing IRR is a challenging process that depends on a prediction of future cash flows, which can in turn be impacted by general market circumstances, risk, cap rates, and other assumptions.
Calculating IRR requires the application of two economic principles. The opportunity cost of capital hypothesis comes first. To account for this, the IRR assumes that there is an opportunity cost associated with choosing one investment over another. The second is known as the time-value of money principle, which holds that given inflation, a dollar received now is higher than the revenue received in the future. A method of discounting future earnings is what the IRR effectively does. Future profits become less valuable the further out they are in the future.
Consequently, you must determine the deal’s estimated annual cash flows to compute IRR. The cash flows comprise (1) rent and (2) property sale proceeds. To calculate IRR, you must be aware of each source’s contribution to cash flow.
Predicting future cash flows and sales revenues can be difficult for even the most experienced investors. In a circumstance where you can rely on a history of cash flows, this is easier to do if you invest in a solid piece of real estate. When you want to keep the property for only a short while, it is also easier to calculate since it is easier to predict a property’s worth three years from now than it is to do so fifteen or twenty years from now. To gain a realistic idea of what potential future cash flows may be, new construction and value-add projects should thoroughly examine comparable deals in the neighborhood. Overestimating future cash flows is a mistake that investors frequently make, and it significantly affects the IRR that results.
Why Isn’t A High IRR Always A “Better” IRR
The sooner an investment will turn a return the greater the IRR, which is an important consideration when using IRR to evaluate passive real estate investments.
Therefore, a project with a greater IRR does not always indicate that it is a “better” investment than another. Even while two projects can provide the same amount of cash flow, the one with the greater IRR will start producing cash flows sooner. On the other hand, a project with a lower IRR may have superior total returns, but they would occur later. For instance, a rapid flip will probably have a substantially greater IRR than a 10-year stay, but the total amount of money the investor would likely get will probably be materially lower.
Equity Multiples Factoring
Investors sometimes employ IRR together with an “equity multiple” to account for time and IRR changes. The cash collected for the holding term, such as interest payments and cash flow distributions, is taken into account when calculating the equity multiple. An investment return on the capital invested in a project is referred to as the equity multiple.
It is simple to determine the equity multiple. The formula is as follows:
- Total Cash Distributions / Total Equity Invested is the equity multiple.
For instance, if an individual invests $200,000 for five years, their total equity investment will be $1 million. The equity multiple will be 2.0x if during that period the acquisition earns $2 million in cash dividends. Alternatively put, investors receive $2 back for every $1 they invest (including their initial investment). This excludes consideration of real estate appreciation.
An investor may spend $100,000 in a venture and, following a rapid flip, may receive $110,000 back. This is why the equity multiple is important when examining the IRR of a deal. Even though this trade appears to have a significant IRR, the equity multiple is only 1.10x. The investor should decide if the purchase, together with whatever dangers it may have, is worthwhile given the 10% return.
Manipulation Of IRR In Real Estate Deals
These computations can be easily manipulated, which is sort of the dirty little secret of IRR. Sponsors may intentionally manipulate cash flows to exaggerate predicted returns because of the fast profits’ disproportionate impact on the IRR calculation. To postpone capital calls, for instance, a sponsor can employ leverage. The sponsor can record a greater IRR by employing a credit line rather than a capital call without significantly altering the deal’s fundamentals.
The majority of sponsors use a pay-for-performance concept. Many investors wait to get paid until their fund reaches a certain level, such as an IRR of 8–10%. Instead of using investor stock, the sponsor can use a credit line to raise the IRR necessary to meet the preferred returns sooner and, as a result, get dividends more quickly.
This type of financial engineering raises red flags and may imply that the sponsor is more concerned with their interests than with that their investors. Furthermore, it explains why investors should consider many factors, such as the equity multiple and IRR when evaluating a deal’s potential profitability.
Applying IRR Vs. Cap Rates
Another indicator that is widely used to evaluate the financial viability of real estate transactions is the capitalization rate, or “cap rate.
The cap rate is calculated as a percentage, frequently falling between 3 and 20 percent, although it can vary depending on the asset category, area, condition, and market timing. The relationship between the value of the property and cap rates is inverse; as the value rises, cap rates fall, and vice versa. Furthermore, as compared to “riskier” transactions, “safer” transactions often have lower cap rates. Investors will be drawn to deals with greater or lesser cap rates depending on their level of risk tolerance.
A property’s cap rate is determined by dividing its unlevered net operating income (NOI) by the purchase price or overall cost of the building. One example of a property with a cap rate of 5% is a property purchased for $10 million and generating $500,000 in net revenue.
The cap rate is calculated without taking debt into account, which is important to know. Since cap rates always imply an outright purchase of a property, they are a valuable tool for comparing purchases without debt skewing the data. A property’s ultimate finance will undoubtedly have a big impact on the deal’s overall outcomes.
The key difference between cap rates and IRR is that the former only offers a snapshot of a property’s worth at a certain point in the investment cycle, whilst the latter offers an overall picture of the entire returns on the investment on annual basis. IRR is like seeing a whole movie, whereas cap rates are similar to gazing at a picture. While both include data, IRR does so in a more compelling manner.
Justification For Passive Real Estate Investors’ Use Of IRR
Investors should conduct their due research while assessing various prospects. This involves contrasting offers based on a range of variables. IRR is a significant measure that may be included in calculations of equity multiples and cap rates. In contrast to cap rates, the IRR takes into account debt, NOI over several years, and both the buy and sale prices.
IRR has the additional advantage of not requiring a “hurdle” rate, like the rate of capital investment or cost of capital. For instance, there are a variety of variables that might affect the cost of capital, including the sponsor’s profile, the amount of stock in the transaction, banking ties, and more. To take these obstacles into account, more knowledgeable sponsors could additionally provide a modified internal rate of return (MIRR).
Knowing When To Use IRR
Investors may wish to use the IRR to estimate an investment’s prospective profitability in a variety of circumstances.
The timeframe of the investment is taken into account by IRR, making it a particularly effective tool for analyzing short- to medium-term investments or those with a defined period and predicted exit strategy. Knowing the cap rate may be sufficient for simpler projects, including investments in two- and three-family homes. However, there is probably a predetermined timeframe within which the investors are anticipating being paid back for larger projects, such as Class A apartment complexes, that involve institutional investors. In circumstances like these, determining a projected IRR is crucial, and the only way to get at that figure is by also projecting an exit cap rate, necessitating the necessity for both computations.
Since IRR may be computed both with and without leverage, it is recommended that any investor who wishes to analyze investment options that take into account the cost of capital utilize it. IRR offers passive investors a crucial viewpoint since various properties can sustain varying levels of leverage and forms of debt.
Conclusion
An excellent instrument for assessing the possibility of a deal is the IRR. Of course, it is not without faults. In contrast to what is frequently the case, it presumes that all positive cash flow is reinvested at the same rate of return as the IRR. As a result of the requirement for significant capital investments, there may potentially be years with negative cash flows.
The issue arises in the fact that it is challenging to foresee the future. It might be challenging to forecast future rent increases or the final sales price. Therefore, even knowledgeable sponsors can make use of somewhat sloppy IRR computations.
However, IRR is a crucial measure that every passive investor has to comprehend. Investors should be aware of how it is determined as well as how it compares to other indicators because it is one of the most often utilized methods for estimating returns.
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