The Practical Shortcomings of the IRR

The internal rate of return (IRR) is a widely used metric for evaluating the profitability of CRE investments, but it has some practical limitations. These include:

1. Multiple Rates of Return: IRR assumes a constant rate of return throughout the life of an investment, but the actual rate of return can vary over time. This can lead to incorrect calculations and faulty decision-making.
2. Timing of Cash Flows: IRR is sensitive to the timing of cash flows and can produce misleading results given cash flows over the transaction life are uneven.
3. Unrealistic Assumption: IRR assumes that cash flows are reinvested into the transaction, which is not typically the case in CRE investments.
4. Ignores the time value of money: IRR does not consider the time value of money and the opportunity cost of invested capital, making it unsuitable for comparing investments with different durations.

For these reasons, it is important to use IRR in conjunction with other financial metrics, such as multiple on equity, average cash on cash, whole dollar profit and NPV to get a more complete picture of an investment's profitability and risk.