Internal Rate of Return (IRR) – Considerations for CRE Investing
IRR and Real Estate Investing – The Basics
Simply put, the IRR (or the “internal rate of return”) is the return percentage an investor is expected to earn over the life of the investment. Expressed mathematically, the IRR is the discount rate applied to a cash flow stream so that the cash flow stream discounted back to the present is exactly equal to the money required to invest at the time of investment. IRR is a broadly used finance metric, but is the primary way equity investments are evaluated in real estate finance.
Professional investors evaluate investments by weighing prospective return by a unit measure of risk. While risk is expressed through credit metrics such as LTC/LTV, DSCR (debt service coverage ratio), and debt yield – return is measured by IRR (Internal Rate of Return), equity multiple, and other key metrics. IRR captures the return of capital and the return on capital over time, which takes many forms in real estate investing. For debt or preferred equity investments, the majority of the IRR takes the form of a stated rate, including both that which is paid currently and that which accrues and compounds to be paid at maturity. Equity investments are more complex.
Equity investments – with uncapped potential upside and a greater range of potential outcomes – require a more nuanced examination of return metrics. The IRR is an annualized return metric that is common in both financial accounting and real estate investing, where the time value of money and liquidity risk are major factors in investment decisions. Note: we will discuss EquityMultiple’s use of IRR forecasts shortly.
Numeric Examples of IRR in Action
Let’s take a look at a couple of illustrative examples of IRR in action.
In this example, the investor is forecasted to earn a 15% IRR over the life of the investment.
Although the IRR is critical for assessing the time-weighted return potential of an investment, it does not tell the complete story and should be one of many metrics considered when evaluating a real estate investment.
To illustrate the limitations of solely depending on the IRR, examine the difference between the two cash flows below that both have the same initial investment of $4MM, a hold period of 10 years, and a realized IRR of 12%.
IRR is a summary annual return metric which includes both the return of and the return on invested capital over the life of the investment. Cash Flow 1, with a lower cash-on-cash return but larger terminal return, is typical of a multifamily investment which requires a great deal of value-add improvement in the business plan – extensive improvement requires a greater disruption of near-term cash flows in exchange for a greater increase in value upon completion. Cash Flow 2 has more significant intermediate cash-on-cash returns, but since there is less of a value-add component, there is a lower terminal value. These two investments exhibit two different risk dynamics and return profiles; while the IRR is the same, investors in Cash Flow 1 would receive significantly less cash flow during the hold of the investment but will ultimately receive more total dollars. As such, the IRR needs to be evaluated in conjunction with average annual cash-on-cash returns as well as the equity multiple to truly balance risk and return properly.
EquityMultiple’s Use of IRR
Each offering available through EquityMultiple is offered through a broker-dealer. Broker dealers are regulated by FINRA and subject to securities regulations promulgated by the SEC. As such, EquityMultiple cannot and does not display any forward-looking projections of IRRs in its marketing materials.
Investors can, however, view target return information (including net investor IRR) within each offering’s Investor Packet. The relevant return metric will vary by the type of investment. For equity investments, there will typically be a target IRR, target cash-on-cash return and target equity multiple. In addition to the target return, investors can access a pro forma. To fully understand any investment, it is important for any prospective investor to read the Investor Packet prior to investing.
For offerings where returns are not fixed, but instead will vary depending on the underlying performance of the investment, return targets will be shown as a range, not a static number. The range will typically reflect the Sponsor’s underwriting – which is set as the high end of the range in our underwriting – versus a more conservative low end that we arrive at through additional risk assessment and stress testing. In other words, EquityMultiple’s Real Estate Team scrutinizes the pro forma assumptions provided by the Sponsor, then layers on additional diligence measures, including data sets for sale and lease comparables. This could mean a reduction or increase to the assumed rent-per-square-foot, exit cap rate, vacancy rates, taxes, lease-up velocity, or other input variable that drive IRR calculations.
These scenarios will be shown in the Pro Forma Financial Summary, an Exhibit of the Offering Listing Summary, part of the Investor Packet found in the ‘Documents’ section of the offering.
In the Investor Packet, the pro forma will reflect the following:
- A table that clearly shows all assumptions used in the displayed underwriting (both the Sponsor’s assumption and the more conservative set of assumptions);
- Two summary pro formas showing a hypothetical illustration of the cash flows from the investment utilizing both the Sponsor’s assumptions and the more conservative set of assumptions; and
- Sensitivity tables showing the impact on returns if critical assumptions are changed.
Sensitivity analysis demonstrates how the change of input parameters (assumptions) would affect the change of the output (realized return). For example, we can show upside or downside effects of cap rate movement, and how that affects the net IRR to investors. IRR forecasts can be useful in assessing the appeal of an equity investment, but investors should keep in mind that realized (ex poste) IRR can be extremely sensitive to timing of exit and payments, and that a realized equity investment’s IRR may exceed or fall short of projection. We show a range of return parameters so our investors are better educated about the impact of different key assumptions and can make a well-informed decision.
We show an aggregate realized IRR figure, which is available on our Track Record tool. Please keep in mind that this aggregates all positions in the capital stack, including fixed-rate (debt and preferred equity) investments that – due to a regular distribution schedule and limited upside – will tend to fall in the high-single-digits to low-teens range.
Limitations of the IRR Metric in Real Estate Investing
The above numeric example illustrates how IRR alone provides no detail on expected cash flow timing. Here are several other dimensions of real estate investments that are critical to real estate investors, but are not expressed adequately by the IRR metric alone:
Business Plan Risk
Generally risk and return potential are positively correlated; in order to achieve an IRR in the ~20% range, investors will need to assume a higher level risk of principal loss. The project will likely entail significant business plan execution risk with capital expenditures in redevelopment and may offer little or no cash flow throughout the early part or the entirety of the hold period. These are two sides of the same coin: in order to carry out significant improvement, and thus realize significant appreciation at exit, there must be significant expenditure or vacancy, and thus room for substantial NOI growth. Or, in the case of a more ambitious value-add redevelopment or ground-up development, the project may require 100% vacancy in order to execute on the business plan. Conversely, a stabilized property (or portfolio of properties) entails significantly less business plan risk which carries less vacancy risk, and less liquidity risk on the part of investors. As such, it generally cannot offer the same opportunity for significantly improved rent rolls and appreciation at exit.
Interest Rate Risk
Commercial Real Estate transactions generate return in several ways, most often cash flow and exit sale proceeds. A shorter duration redevelopment business plan carries greater interest rate risk due to the majority or entirety of the investment yield being dependent on the exit sale price, which in turn depends on the exit capitalization rate (generally abbreviated as “cap rate”) which the eventual buyer will agree to pay. Cap rates are expressed as a yield derived by dividing NOI by purchase price. The cap rate that an investor is willing to pay on a property will fluctuate by property type and location and is also strongly correlated to market interest rates. Just as in bond math, a higher exit cap rate would yield a lower project return. Just evaluating the prospective IRR of an investment ignores the timing of the sources of return which generate that IRR.
Because IRR places such emphasis on time, a high IRR does not necessarily mean a large profit harvested at the exit of an investment. In order to assess the total profit potential, the project IRR must be viewed in combination with the equity multiple. The equity multiple is the simple representation of how much profit was generated in relation to the investment or a whole dollar return on that investment decision. Let’s again compare a hypothetical value-add investment against a more stabilized portfolio investment:
- Value-add: the riskier project yields a 1.73X equity multiple ($7,280 plus return of principal on a $10,000 investment) after a 3-year hold with no intermediate cash flow.
- Stabilized Portfolio: the significantly lengthier hold period weighs down IRR. While the IRR is only 10%, the investment yielded consistent cash flow throughout (9% per year, an average of $900 on this hypothetical $10k investment). The equity multiple is a more favorable 2.06X, while the investor assumed significantly less risk by participating in a stabilized portfolio of properties which derived its return from multiple sources of cash flow (intermediate distributions and exit sale proceeds).
In this hypothetical example, the value-add investment would have yielded an IRR in the neighborhood of 20% (depending on exact timing of exit), significantly higher than the stabilized portfolio. However, the realized total return and equity multiple of the stabilized portfolio are significantly higher, albeit over a much longer term.
This hypothetical example does not prove that either profile of investment is better, as each should be examined through the lens of the investor’s risk preference. It does illustrate that IRR can be misleading when evaluated in isolation.
The Bottom Line
IRR can be a very useful snapshot return metric for equity real estate investors, particularly those seeking to understand the time-weighted return potential of an investment. Like other return metrics, IRR should not be considered in a vacuum. A single return metric should only be used for apples-to-apples comparison when the risk profile and target hold period of two potential investments are similar. To evaluate more disparate real estate investments, it is more valuable to examine all available return metrics in the context of your investing strategy, risk preference, and composition of your individual portfolio.
To help you better evaluate potential investments, EquityMultiple provides applicable return metrics within the investment documents of each offering. For equity investments, this will include a target IRR range. Should you have any questions regarding these figures and how they were determined, please don’t hesitate to reach out to our Investor Relations Team at firstname.lastname@example.org.
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