One of the most elusive terms for real estate investors is the IRR, yet it is one of the most important. A new passive investor needs to beef up their investing vocabulary, and IRR is in the middle of that dictionary. You've been getting a handle on terms like cap rate, capital stack, NOI, ROI, and they all seem to make sense, but when you come upon the IRR, maybe your eyes gloss over (or cross). What separates this one from all the others? In a word, time, or should I say the time value of money.
While capitalization rate might be the most popular metric when evaluating an apartment building, IRR might be the most important measuring stick for many investors when assessing an investment opportunity. In this article, you're going to learn what IRR is, how it's different from ROI, how to calculate the IRR when looking at a deal, and why you should even care about the IRR.
By definition, the internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments, but that doesn't make it sound much different from an average annual return or total return.
Time is The Key Ingredient When it Comes to IRR.
I am guessing after you read the definition above, you are no clearer about what IRR is. Don't be too concerned. If you are investing in an apartment complex, you need to know that a higher IRR is good, just as with any metric. But as I mentioned before, what separates it is the inclusion of time into the equation.
IRR (internal rate of return) is the standard metric used to compare the return on your investment with the length of time included in the calculation. In contrast, ROI (return on investment) calculations don't consider how long it will take to collect your returns.
We can ask if your initial investment was $100K and you earned $300K, is that a good deal? Before you answer this question, the time has to be included in the equation, or you don't have all the information you need. IRR considers time, whereas another metric like the equity multiple does not, so it is essential to have both when evaluating commercial real estate investments.
If you invested $100k into a real estate syndicate and got back a profit of $300k plus your principal, you would have an equity multiple of 4x. That sounds amazing, but if it took 40 years to make that 300% return, a higher equity multiple doesn't mean much. IRR takes care of this time factor. In general, if you earn a solid return over a short number of years, say three to five years, you will have a high IRR and an excellent investment - very efficient use of your capital. This is why you will see sky-high IRR's on real estate syndication deals that go full cycle (Purchased through disposition) in two years.
In contrast with the 4x equity multiple over 40 years example, your IRR would be extremely low because it took way too long (for lack of a better term) to make you that $300,000. When we are talking about the velocity of capital, time plays a significant role, and therefore, IRR becomes your most important metric.
Again, I can show you this fancy formula that I captured from Investopedia:
Further Definition: IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.
I think it is much more effective to tell you that cash flows over a shorter hold time result in a higher IRR, while cash flows over a longer hold time result in a lower IRR.
The ROI isn't beneficial for passive investors comparing a five-year value-add opportunity and a seven-year syndication deal. It would help if you had the IRR to include the length of time your capital is invested and accurately compare the returns you might earn. As Ben Franklin said, "Time is money."
Keeping It As Simple As Possible
It would be unclear to compare different deals of varying lengths, classes, and types without a clear IRR on each deal. Fortunately for you, the investor, you don't need to calculate the IRR. Any deal sponsor such as Fortress Federation provides IRR along with a chart of other variables so you can see clearly how the IRR may be affected in the sensitivity analysis in the deal's offering memorandum. Now, if you want to become granular in your due diligence, you can learn the formula for IRR, and there are spreadsheets and calculators available online.
A key thing to remember is that the more monthly distributions paid to investors in a shorter timeframe, the faster IRR turns positive. This is why monthly distributions (most pay every quarter) and early sales are popular because they raise the IRR. Wouldn't we all love to double our money in three years instead of five?
It Isn't Only Time That Affects IRR.
You may notice an easy-to-find IRR printed in the executive summary, but it is based on the entrance cap rate. The IRR moves as the cap rate moves. In the sensitivity analysis, you should be able to see a chart similar to that below, where a varying cap rate, among other factors, reflects an adjusting IRR.
The asset class and strategy also intensely affect the expected IRR on any syndication investment.
Although these are both apartment complexes, possibly even in the same metropolitan area, you're comparing two different appreciation strategies and two different classes. A stabilized A-class apartment syndication may have a 7-year term with no refinance opportunity and an IRR between 13%-15%. In contrast, a B-class value-add multifamily syndication may reflect a 5-year business plan, refi opportunity, and forced appreciation from the renovations that push IRR up into the 14%-17% range.
Adding income streams to the property, increasing operational efficiencies, and getting units to market rents are all ways underwriting can affect IRR. Things like laundry services, mail delivery lockboxes, new property management, and payment software for tenants could drastically improve the experience for tenants and support higher rent rates. Overall property upgrades with generally low costs will increase demand and raise the rental rates; the NOI (net operating income) will get a bump and positively impact the IRR.
Alignment of Interests
Beyond the metrics and acronyms, you should examine each prospective deal for its alignment with your strategy. Consider the types of syndications you're interested in - multifamily, mobile home parks, developmental, and self-storage, for instance. Consider the exit strategy - is it a long-term hold period, or is it a relatively short-term renovation with a refinance and a return of capital? How does the operator's business plan align with your investment strategy? Maybe you are looking for a long-term hold with high cash on cash return, but the operator is looking to push IRR by increasing the value quickly and selling within a few years.
Are you familiar with return hurdles, also known as a waterfall structure -another area where the IRR comes into play. If the deal hits a specific IRR, say 14%, the profit split or equity split changes. This is where you want to pay close attention to the private placement memorandum and operating agreement to make sure the deal's structure and business plan align with your strategy.
Each varying asset type, class, and market boasts different metrics. Weigh whether the market exhibits high growth trends in favor of increased occupancy and rent rates and decide if you're comfortable having your investment capital locked in for three, five, or seven years.
Another significant factor is, of course, the operator. As for a track record to get an idea of past performance. Do you agree with their philosophy and the way they run their business? Do you know, love, and trust them? Fortress Federation's philosophy includes capital preservation first, followed by monthly distributions, and then appreciation. Therefore, we specifically seek out investment opportunities with these goals in mind.
The breakeven occupancy rate, expense ratio, the deal structure, and loan or debt details also need careful inspection. In general, if the breakeven occupancy rate and expense ratio are low, the projections are more likely to be achieved. Deal structures can vary between a wide array of preferred return percentages and splits for distributions, and loans on the property can reflect a wide range of rates, terms, and other options.
As always, your selection should be in line with your values and investment goals, plus within your risk tolerance.
IRR tends to make our eyes roll gloss over, and for this reason, investors may pay more close attention to other metrics like the Average Annual Return or equity multiple. Just remember, those other metrics don't factor in time the way IRR does. So, for this reason, give IRR the attention it deserves. If you ever want to talk shop, I am always available for a chat.
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