IRR, or the internal rate of return, is a good thing to get familiar with if you're interested in measuring investment performance in commercial real estate. Even though IRR is commonly used throughout the investment and real estate industries, it is one of the most widely misunderstood terms around.
When working with investment performance measure in commercial real estate, it’s important that you know IRR inside and out. Clearing up some of the common misconceptions around IRR can help you understand the intricacies of investment performance measure. If you have no clue what IRR is or where to begin to understand it, you’ve come to the right place.
Below we’re going to start off by defining exactly what IRR is in terms that everyone from novice to expert will understand. Then we’re going to walk you through how it works with real-life examples. Finally, we’ll go through why it matters and how companies use it in the real estate world today, ending with some common mistakes people make when working with IRR. By the end of this article, not only will you have a better understanding of what IRR is and how it works, but you’ll be able to apply it to real-world situations.
IRR stands for Internal Rate of Return, but simply knowing what the acronym means does not make you an expert on its definition. The most basic definition of an internal rate of return is the annual rate at which the project breaks even. But before we go any further defining IRR, we have to define NPV.
NPV, or Net Present Value, is a vital term to know when trying to understand IRR. The net present value is how much an investment is currently worth, as compared to a series of future cash flows with a discount rate applied. This discount rate is typically based on a company’s required return to fund a project, say 14%. The required rate of return is the minimum annual return that a company will accept before embarking on a project. Companies set their required rate of return based on the minimum of what they believe they could make on an alternative investment.
When a project has an NPV of more than zero, that means that you will make more than your discount rate (generally your required rate of return). This positive NPV would imply that the investment is worthwhile. To sum, an NPV is the sum of all cash flows at a discount rate representing your required rate of return. So what does this all have to do with IRR?
IRR is the rate that your NPV equals zero, or the discount rate at which the project breaks even. Generally, financial analysts use IRR and NPV in conjunction. While it’s necessary to know the
definitions of both IRR and NPV to understand either one, it’s important to not get them confused or mistake them for the same thing.
For the sake of clearing up confusion, let’s take a moment to break down the difference between IRR and NPV. When we’re talking about NPV, we’re talking about assuming a particular discount rate for your company. With this particular discount rate, you can then calculate the present value of the investment by applying the discount rate to a series of projected cash flows.
The difference between NPV and IRR is that with IRR you calculate the actual return provided by the project’s cash flows. You then compare that rate of return with your required rate of return. Once all that calculating and comparison is through, if you find that the IRR is higher than your required return, the investment you’re considering would appear attractive.
Having discussed the definition of IRR, we’re now going to walk through how it works and how exactly one calculates it. Unfortunately, IRR is not a straightforward calculation and it does not come with a simple formula that can be followed. Instead, it’s a calculation that is company and situation specific depending on you and your investment.
In the past, most people had to calculate IRR by hand. With the advent of the computer era, however, it’s now much easier to figure out your IRR by utilizing financial software or a financial calculator. If math isn’t your strong suit, don’t sweat it. Calculating your IRR can be done by anyone with the right data and software.
While you may not need to know how to calculate IRR by hand, it is important to get an understanding of what’s going on when you insert those numbers into your Excel spreadsheet. We’re going to walk you through a step by step example of IRR that you may find looks similar to calculations you have to do in the real-world.
Here’s an example of cash flows that you may be faced with:
What this cash flow is saying is that if you made an investment of $100,000 today it would grow to $161,051 in five years time. That means the IRR is 10%. But how did we our spreadsheet come up with that exact IRR number? Well, let’s take a look.
If we look at this chart above, we’ll see that in year one we’ve invested $100,000. With an IRR of 10% the next year, our investment value increases by $10,000 and is now $110,000. This same pattern repeats for each subsequent year, adding 10% to the value of the previous years total During the fifth year, our final investment value totals $161,051. How did we get this number? It’s simply a sum of the 10% per year return of investment (or 10% increments that were added onto our investment over the five years) plus our original $100,000 investment.
When you put IRR this way, with real examples and numbers in front of you it’s much easier to understand. Instead of defining IRR as the rate at which the project breaks even, it makes more sense to call it the percentage rate earned on each dollar over the period it’s invested.
IRR is used by many companies in the real estate industry because it is a standardized way to measure investment performance. Most companies use NPV and IRR in tandem with one another to evaluate their investments. Both metrics are often evaluated because NPV is able to tell you more about the total dollar value a company can expect from an investment while IRR is used to present the annual return.
IRR is often used when giving presentations to people unfamiliar with financial jargon who need an easily digestible way of understanding the investment at hand. IRR is intuitive and easier to understand because it breaks down your return of investment step by step rather than presenting it as one lump sum like NPV.
The only problem companies face when relying on IRR is that it’s a more conceptual figure than a specifically calculated NPV. IRR doesn’t give you the answer in terms of cold hard cash, but instead presents you with a percentage that doesn’t address the scale of the dollar amount invested.
One of the biggest myths when it comes to calculating IRR is the reinvestment rate assumption. The reinvestment rate assumption is when the IRR assumes interim cash flows (cash flows received before the investment has been disposed) are reinvested at IRR. While this may seem to make sense on the surface, when you dig a little deeper it’s easy to see that this isn’t always feasible.
Many companies now reinvest IRR interim cash flows, causing a huge misconception in the understanding of IRR as a whole. If you take the time to understand IRR at a step by step level then it’s easy to see that there is no column for reinvestment rate assumption. While companies may very well receive periodic cash flows on their investments throughout the years, there is no way of knowing what they do with those cash flows. It would be inaccurate to assume that the interim cash flows are automatically reinvested at the calculated IRR.
At this point of the article, you should have a pretty good understanding of what IRR is and how it works. Now we’re going to move on to some of the common mistakes people make when calculating IRR. By learning what mistakes are the most common, you can take extra precautions to avoid them on your next IRR calculation.
The biggest mistake people make when using IRR is only using IRR to measure investment performance. While IRR is a very helpful and powerful way of understanding your investment performance, it works much more effectively when used in tandem with other measuring method. As we mentioned earlier in this article, the most commonly used method along with IRR is NPV. When you use the two together you can create a fuller and more comprehensive understanding of your investment. Companies that only use IRR when looking at their investment, often end up making poor choices about where to invest their money.
Another common mistake people make when using IRR is that they don’t take into account how IRR measures the time value of money. Like we talked about with the IRR reinvestment rate assumption myth, most people assume IRR calculates the future cash flows from a project as being reinvested at the IRR when this is not necessarily true. To help offset this assumption, try using IRR with a modified internal rate of return, or a MIRR, that assumes the positive cash flow is reinvested at the firm’s cost of capital. To play it safe, you should always use IRR in conjunction with NPV to get a complete picture of your investment.
In conclusion, IRR matters to companies because it allows them to rank their investments by overall rates of return rather than the specific dollar values that NPV gives you. This way, when you’re looking at all of your company’s projects side by side, you’ll have a standardized way to measure the projected rate of return for each project.
In addition, when you calculate your IRR you are not measuring the absolute size of the investment. This means that your IRR is able to favor investments with high rates of return regardless of the actual amount of dollars returned. If you were relying on NPV for this information, your investments would be ranked on dollar amount rather than percentage even if the percentage for some investments were higher.
If you’re looking for a great way to use measure investment performance in your commercial real estate projects, IRR is an excellent metric to have in your tool kit. Now that you have a more complete understanding of what IRR is and how it works, you’re ready to go out into the world with the knowledge you need to make smart investments.