IRR Deep Dive: Let's Learn How To Use This Little Metric
In real estate investments, IRR is used to compare deals and make investment decisions. It is used together with other return metrics, such as cash-on-cash return, equity multiple and average annual return (my favorite metric). In the world of investments, the Internal Rate of Return (IRR) percentage is a metric used to determine a rate of return based on Net Present Value of money.
What is Net Present Value of money?
What is IRR?
Why is IRR important?
Why is IRR used in syndications?
Why is IRR used to compare multifamily projects?
I have railed on this metric previously, mostly because I often hear it misused, but I was asked to do a "deep dive" to simplify it for those that haven't heard of it or don't fully understand it.
Time Value of Money. First, let's discuss Time Value of Money. Time Value of Money is the idea that future money has less value than presently available money, due to the earnings potential of the present money. Put another way, future money is worth less than today money. Future money is also less valuable because inflation erodes its buying power. This is called the time value of money. This is why we invest! This is why cash under a mattress is not a wealth building idea. Money that is not working for you is working against you, as it depreciates with inflation.
Net Present Value (NPV). What is Net Present Value? How exactly do you compare the value of money now with the value of money in the future? A project or investment's NPV equals the present value of net cash inflows the project is expected to generate, minus the initial capital required for the project. The theory states that if an investment has a Net Present Value greater than zero, a positive NPV, that investment should increase the shareholder's wealth. If an investment has an NPV less than zero, if the NPV is negative, the project is not a good one and it will ultimately drain cash from the business.
Future money is worth less than today money = Present Value
Internal Rate of Return (IRR). IRR has entered the chat. The IRR is the discount rate that will bring a series of cash flows to a Net Present Value of zero. Check out the below formula:
What we are solving for is "r", which is the percentage rate you see packaged up with the investment offerings. This is the discount rate that is driving the NPV to zero. Think of discounting as compounding interest working backwards in time. Discount Rate can be interpreted as the Cap Rate plus expected NOI growth, representing the income and growth components of total required rate of return respectively.
Let's dissect the formula real quick:
T = Above the sigma, is the total periods (usually years)
t = Everywhere else, is the time period
Ct = cash flows in the period
Co = initial investment
r = the discount rate (IRR)
"Periods" is the amount of years a project or property is being held.
Continuing on. The bottom portion of the fraction, where our discount rate is, is what's called a "discount factor." Multiplying the projected cash flow by the discount factor a certain period gives you the Present Value of the cash flow. of a specific period.
Now that you have your Present Value for the period, we are looking for the rate that makes the NPV equal to zero. So:
(Total Present Value) - (Initial Investment) = Net Present Value
Think of discounting as compounding interest working backwards in time.
There are a three nuances that I want to highlight: leveraged IRR, unleveraged IRR and negative IRR. As an investor, you must understand what these mean and how they are used. Let's take them one at a time.
Leveraged IRR: Levered cash flow is the amount of cash that a property produces after operating expenses and debt service (loan payments). This is used when there is a mortgage on the property.
Unleveraged IRR: Unlevered cash flow is the amount of cash that a property produces before taking into account the impact of loan payments. It acts as if the property were purchased all cash.
Negative IRR: Negative IRR occurs when the aggregate amount of cash flows caused by an investment is less than the amount of the initial investment.
Please let me know if this makes sense. What we do at Ten15 Capital is evaluate the IRR versus the projected cash flows of the project to determine when the best time to sell will be. It is not always at the end of the hold term. On some projects, the IRR is a sliding scale that accelerates, then flattens out, then starts to diminish, but it is always analyzed when it is positive.
How do we use the IRR metric? We use the IRR metric to determine the best time period to sell the property and maximize our profit.
Money that is not working for you is working against you
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