There seems to be a big buzz around the IRR when it comes to investing in multifamily syndications. Everywhere you look, read, or hear, investors are throwing around IRR percentages like they’re something you’re supposed to know. Well, do you know? In my experience, 7 out of 10 sophisticated investors do NOT know what that is! Ask a “syndicator” and you’ll be surprised at how many have no idea what IRR even stands for. It’s crazy. Also, 7 out of 10 statistics are made up, but you get the illustration. Why is it popular to use that as a barometer to gauge the value of an investment?
The first time I saw a calculation for Internal Rate of Return was while in school for my Electrical Engineering degree. There is a required course in Engineering Economics, which teaches cash flow diagrams, present value, discount rates, internal rates of return (IRR), income taxes, inflation, net future value etc.… This is also a requirement in the Professional Engineering examination for the state licensing.
What they're telling me is that you, as the passive investor comparing deals to invest in, need to understand engineering economics before deciding on which deal to go in to?
I’m going to break down what this is, and then I’m going to hit the “backspace” button and never look at it again! But before we create the whitespace and delete like in Eternal Sunshine for the Spotless Mind, I’ll give you 3 reasons why it’s cool not to care about IRR and give you tools to really look at when comparing multifamily syndication investments.
What is IRR? What does the internal rate of return mean? The internal rate of return can be defined as the break-even interest rate which equals the Net Present Worth (Net Present Value) of a project in and out cash flows. It is worth defining Net Present Worth here, it is the present value of a stream of payments in today’s dollars, a time value of money. The Time Value of Money (Present Discounted Value) refers to the idea that a dollar today is worth more than a dollar in the future because of its earning potential over time. This concept is based on the core assumption that money is worth more the sooner you receive it.
Let’s nerd out: Consider this formula: P(irr) = Fcash_in - Fcash_out. P is Net Present Worth, (irr) is the internal rate of return interest percentage, Fcash_in is the future cash flow in (discounted), Fcash_out is future cash flow out (discounted). Further, P(irr) = F0 / (1 + irr)0 + F1 / (1 + irr)1 + F2 /(1 + irr)2 + .... + Fn /(1 + irr)n where “cash out” would be your initial investment. In these equations, the “cash out” (or your initial investment) is a negative value, and “cash in” (projected cash flows) are positive values. The chart below illustrates where the IRR interest rate would be, which is when the curve passes the “X” axis which represents zero or breakeven.
What they're telling me is that you, as the passive investor comparing deals to invest in, need to understand engineering economics before deciding on which deal to go in to?
How did you determine what the minimum acceptable Internal Rate of Return for a project investment is that you would accept? I’m asking YOU! Since multifamily syndicators are presenting you their deals, they are assuming you have this criteria already set for you and your funds. The thing is, before real estate syndications were available to you and me, syndicators would only deal with Accredited Investors Most of them are high net-worth that live in the financial space and have all these criterion set up in their investment house. As a Sophisticated Investor, you and I don’t. We need a more “normal” base.
Reason #1: IRR is not simple
Check out the dissertation above! IRR is not simple. You know what is? Cash flow.
I like to talk in terms of cash on cash returns and cash flow. That is simple. Cash on cash returns (CoC) are a simple calculation: sum of all cash flow received in a one-year time period, divided by total investment in. That’s it. Ditch the engineering cash flow diagram, that gave me a headache anyways.
Example:
You invested $25,000 in one of our deals. We direct deposit $187 every month for this year. Your total cash flow was $2,244. Divide that over your initial $25,000 investment and that gives us a 9% Cash on Cash return. Simple arithmetic.
P(irr) = F0 / (1 + irr)0 + F1 / (1 + irr)1 + F2 /(1 + irr)2 + .... + Fn /(1 + irr)n
Reason #2: IRR is time based
Most syndications are calculated around a 5-year hold. Typically, the shorter the hold period, the higher the IRR. If you take the same project and stretch it a 6th year or a 7th year, which is realistic, your IRR drops.
I like to talk in terms of Average Annual Return. It is simple and is also time based. It adds up the sum of all cash flow received over the life of the project plus the equity split on the profit made on the sale of the asset over the hold time. That’s it. Ditch the engineering cash flow diagram, that gave me a headache anyways.
Example:
Using the Cash on Cash example above, let’s assume this is a 5-year hold and cash flow is constant at $187 per monthly distribution. Total cash flow over 5-years is $11,220. After year 5, we have a liquidation event where we sold the asset, and your equity position yielded $16,250.
Let’s add up the total cash flow received, $11,220, with the equity received, $16,250, for a total return on investment of $27,470. Divide that over your initial $25,000 investment which gives us a total return of 110%. Divide this by 5 (hold time 5 years), and you are earning an Average Annual Return of 22%. Simple arithmetic.
IRR is not simple. You know what is? Cash flow.
Reason #3: It is not apples to apples
When comparing two apartment syndications and considering which to invest in, you can’t blindly look at the two IRR’s and make a decision on that. One of the flaws of IRR, or major disadvantages of IRR in comparing deals, is that if one project has a hold of 10-years and the other 7-years, you are not comparing apples to apples. The IRR cannot apply. You would have to do the above calculations in order to compare the two correctly.
Example:
I have seen this in the real world. Project A is a 5-year hold with a 15% IRR and Project B is a 10-year hold with a 13% IRR. Both offered 7% cash on cash returns. If I only look at IRR, I’m picking Project A, right? However, when I looked at the Average Annual Return, Project A was at 17% while Project B was at 23%. This is HUGE! Project B is giving me way more actual capital in my bank account.
In the words of the late great Ol’ Dirty Bastard, “Keep It Simple, Son”!
I like to talk in terms of Average Annual Return. It is simple and is also time based. It adds up the sum of all cash flow received over the life of the project plus the equity split on the profit made on the sale of the asset over the hold time.
In Conclusion:
One of my friends and mentors, Kevin Kolinksi, loves to talk in these hyper intelligent engineering economics terms, especially if we’re eating mofongo (must be the garlic)… but, he’s a savant and speaks in a futuristic language. I don’t! I like simple! I like to be able to speak to my nieces and break investing down to their level. I like to talk to my friends at the brewery and break a deal down quickly. For this, IRR is not the metric for me.
"Ditch the engineering cash flow diagram, that gave me a headache anyways." - Duamel Vellon
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