THE PERILS OF RELYING SOLELY ON IRR AS A REAL ESTATE INVESTOR

Over the past several decades our sophistication with respect to the evaluation of investment returns has dramatically increased.? This is true both for corporate finance as well as the world of real estate.? We have moved beyond exclusive reliance on metrics such as payback period and total net cash flow realized—often expressed as a multiple of invested capital—in favor of annual cash-on-cash returns, cap rates and internal rates of return (“IRR”).? I have written elsewhere about the use and misuse of cap rates, which is essentially built upon the concept of cash-on-cash returns.? See “Cap Rates—Sense and Nonsense” (2013, updated 2023), which will be available on my website www.simonjawitz.com ?early in 2024.? To incorporate the crucial concept of the time value of money into the analysis, real estate investors have enthusiastically embraced the more complex financial concept of IRR.[1]? Computers and spreadsheets have made this easy to do and it is relatively rare that an offering memorandum for a real estate transaction will not highlight the projected IRR.

While use of IRR most assuredly represents a major improvement over older and sometimes embarrassing metrics, the IRR needs to be well understood if it is going to be relied upon as a useful tool of analysis and comparison.? It has been noted elsewhere by well-known and respected authors and firms that IRR is poorly understood even by the very real estate professionals generating transactions as well as the investors committing capital.? See e.g., “Internal rate of return: A cautionary tale” by John Kelleher and Justin MacCormick, McKinsey (Aug. 1, 2004); “The Importance, Limitations and Concept of ‘Quality’ IRR” by Danny Kattan, Forbes Business Council (Sept. 29, 2021).

So, what’s wrong with IRR and why is it so misunderstood?

Let’s start with the easy points.?

First, anyone who has done any financial modeling and worked with the IRR function knows that projects or investments that generate both positive and negative cash flows will often come with multiple IRRs.? If you acquire real estate, expect to operate it for positive cash flow and then make a substantial additional investment, the forecast for the project may display multiple IRRs.? To illustrate the problem without getting into a complicated example, assume you are analyzing the following sequential annual cashflows: (200); 900; (700); 100.? This will produce two wildly different IRR calculations, -24% and 256%.[2]

Second, the calculation of IRR ignores the size of the proposed investment.? In a world where investors need to make choices among competing investment opportunities, this is a serious shortcoming.? Would you rather invest $5 million with an IRR of 18% or $40 million at an IRR of 12%?? While the former is obviously more attractive in IRR terms the latter is likely to create more value for the investor.? This problem is obviously avoided if one calculates the net present value (“NPV”) of the project based upon the appropriate cost of capital.

Now let’s look at the more challenging and often misunderstood point that needs to be clearly understood by investors analyzing the expected returns from a real estate (or any other) investment.?? The IRR is typically defined as the discount rate which when applied to the projected cash flows results in a NPV of zero.? Unless you have taken an introductory corporate finance course, this definition probably doesn’t provide much insight or clarity.[3]? In plainer language the IRR is described as the compounded annual return looking at the cash inflows and outflows and their timing.? Investors compare the IRRs of projects (let’s assume of equal size) and choose the investment with the higher IRR.? This strategy overlooks the fact that the proper definition of IRR is more nuanced and, in fact, more nuanced in ways that often result in investors not understanding the true return profile from an investment.

A better definition of IRR is “The IRR is the single rate of interest that when applied to each of the positive cash flows as a compounding factor from the date of receipt until maturity, and then applied as a discount factor to that total future value results in an NPV of zero.” ?While this is a bit of a mouthful, it makes explicit that the IRR function assumes that all positive cash flows received during the term of the investment are reinvested until the end of the investment term at the IRR.? Additional future negative cash flows are discounted back to the present also at the IRR.

Let’s try to visualize exactly what we mean with a very simple example. Project B has a calculated IRR of 20.78%.

As can be seen from the above, in calculating the IRR from the projected cash flows the IRR compounds the cash flows received in years 1-6 to year 7 at the IRR (look down each column) and then discounts this total figure back to the present also at the IRR (look from right to left).? One thing should be immediately apparent.? Unless the proposed transaction has a single cash outflow at inception and a single cash receipt at maturity the IRR will not precisely reflect the expected return.[4]? It is ironic that the higher the calculated IRR and the more exciting and unique the investment appears to be, the less reliable will be the IRR.? Moreover, the higher the level of interim cash flows and the earlier in the projected timetable they are to be received, the more “inaccurate” the IRR will be.[5]?

While certainly not market practice, the reinvestment risk problem inherent in IRR calculations can be addressed by using a calculation called the modified internal rate of return (“MIRR”), which is available in EXCEL, Google SHEETS or other financial software package.? Unlike the IRR calculation, the MIRR requires the user to input an explicit reinvestment rate to be applied to cash distributions before maturity and a financing rate to be applied to any negative cash flows that need to be financed to maturity.[6] ?

Applying this to the cash flows shown above yields the following:

IRR = 20.78%

MIRR = 13.8% (assuming reinvestment and financing rates of 6%)

MIRR = 14.7% (assuming reinvestment and financing rates of 8%)

If we need to accommodate additional negative cash flows during the term of the deal this can also be done. Suppose the project requires an additional investment of $25 in Year 1.

MIRR = 10.6% (assuming financing rate of 6% and reinvestment rate of 8%).

This is equivalent to the following:

Step 1: Discount ($25) back one period at 6%. Total Now cash flows = ($243.58)

?Step 2: Compound all positive cash flows forward to Year 7 = $494.3

?Step 3: Find the IRR of these two cash flows = 10.6%

As I noted above, this type of analysis is rarely—if ever—used in practice.? There are both bad and good reasons for this.? Deal sponsors are anxious to present their transactions in the best possible light, especially since competitors are certainly doing so.? It is also fair to say that reinvestment and financing rates are hard to define and with respect to the reinvestment of cash distributions are certainly going to vary from investor to investor.? It is also questionable whether using assumptions extraneous to the actual transaction provides a useful way to measure transaction returns.

The incorporation of IRR into financial analysis has certainly been a significant step toward more sophisticated and complete calculation of expected returns.? It incorporates the fundamental concept of PV into valuing anticipated future cash flows and therefore represents a significant improvement over prior metrics.? However, while there is certainly a strong temptation to take the IRR at face value, a more nuanced understanding is likely to lead to better investment results and less cases of investor’s remorse.

[1] Investment memoranda for commercial real estate transactions often show the multiple of invested capital, going-in cap rates, projected exit cap rates and the anticipated IRR.

[2] The experience is likely to be even more unsatisfying as you need to check for multiple IRRs by running the IRR calculation with varying ‘guesses’ in the formula.

[3] Even if you have taken an introductory corporate finance course you may still be scratching for head and wondering what it all means.

[4] The same is true of a purchase of a bond.? The yield-to-maturity (“YTM”) assumes the reinvestment of all coupons at the YTM and therefore will only be exactly accurate in the case of a zero-coupon bond.

[5] Another way of expressing the same idea—which is mathematically equivalent—is to say that if all the cash flows from the project are invested at the IRR until maturity the resulting amount will be the same as if the initial investment was simply invested at the IRR until maturity. ?In our example, the $824.76 is the same as if you invested $220 at 20.8% until maturity.? $220 x (1+.2078) ^7= $824.76.

[6] Essentially what you are doing is reinvesting all interim cash flows at the chosen reinvestment rate until maturity and then solving for the discount rate that gives you a present value (“PV”) equal to your initial investment plus the PV of any interim negative cash flows discounted at your chosen financing rate, i.e. no NPV.? For those more mathematically inclined, unlike the IRR the MIRR can be expressed as a single formula:

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