What are the best practices and tools for IRR modeling and forecasting in CRE fund management?

Timing of cash flow distributions is important—earlier cash flows help drive up internal rate of return (IRR), a time-wtd avg annualized return. Cash distributions now > cash distribution later. The reason being is that later cash flows are discounted more heavily than earlier cash flows. Magnitude of cash flows also comes into play—uneven cash flow distributions due to not only a return on capital, but also a return of capital. Depending on the waterfall structure, cash flow distributions could vary by deal—sometimes the preferred return (“pref”) could be reached sooner. If you compared the cash flows & IRRs above using IRR partitioning, you could also bifurcate IRR attributed to operating vs reversion cash flows.

Several factors, or "drivers," influence the IRR of an investment. Understanding these drivers is crucial for making informed financial decisions. The main drivers of IRR include: 1. Cash Flows: The timing and magnitude of cash flows. The more significant and sooner the positive cash flows, the higher the IRR. 2. Investment Horizon: The length of time an investment is held can GREATLY affect IRR. A longer investment horizon generally results in a lower IRR due to the longer wait for returns. 3. Initial Investment: The amount of money invested upfront can influence IRR. A higher initial investment often leads to a lower IRR because the cash flows generated must be sufficient to offset the larger initial cost.

There are different “levers” you can pull to “juice” your investment return—using more debt/leverage, higher rent growth, shorter hold period, lower market exit cap. That being said, it’s important to run sensitivity analyses/data tables to sensitize these inputs to test how changing them impact investment returns. Crazy rent growth, cap rate compression etc likely aren’t sustainable for the long term; also might need to hold a deal longer to “ride out” unforeseen challenges etc. So if a deal pencils on a downside scenario, there’s more “meat on the bone” & buffer room to hit your targeted returns—don’t want to rely on best case scenarios.

A reduction in 50 basis pts (bps) in your mkt exit cap could make a significant impact to your reversion value & overall return, incl. internal rate of return (IRR). Forward 12 mo net operating income (NOI) of $500K / 5.5% cap = $9M vs $500K / 5.0% = $10M, so that’s a +$1M diff using -50bps on the market exit cap. For sensitivity testing, +/- 25bps intervals are typically used for downside & upside scenarios from your base case number on cap rate, etc. Sensitivity analysis is typically done in a data table in Excel; scenario analysis can involve creating iterations of the model etc.

Using an error-free, professional underwriting model is critical. We struggled to find a great underwriting model to calculate IRR and other metrics for our deals, so we had to create our own. Investors need to use an accurate underwriting model for their investments.

Data and analytics play a crucial role in calculating the Internal Rate of Return (IRR). To calculate IRR, you can follow these steps using data and analytics: Data Collection: 1. Gather historical or projected cash flows related to your investment. These should include all cash inflows and outflows over the investment's life. Data Formatting: 2. Organize your data into a structured format, typically in a spreadsheet. Use columns to represent each period (e.g., months or years) and rows to specify different cash flows. Initial Investment: 3. Identify and input the initial investment or acquisition cost (typically a negative cash flow at the start of the project).

When presenting your IRR, it's essential to ensure your communication is transparent, concise, and engaging. To achieve this, employ straightforward and uniform language, formatting, and industry standards. Enhance your message with visual tools like graphs, charts, and dashboards. Additionally, emphasize the fundamental factors, assumptions, various scenarios, and associated risks and uncertainties underpinning your IRR analysis.

IRR is a key tool in real estate for evaluating investment opportunities, understanding their potential returns, and making well-informed financial decisions. If you invested $100,000 and received back $400,000, is that a great investment? Well, it depends... On that amount of time it took to receive that $400,000! IRR helps investors determine if that is a 'good' deal or not based on the amount of time involved.