Introduction​

In real estate, Internal Rate of Return (IRR) is a metric used to evaluate the profitability of an investment over its lifetime and is represented as the average annual return percentage. Put simply, Internal Rate of Return is the discount rate that brings a series of future cash flows back to a net present value of zero. Internal Rate of Return uses the time value of money (TVM), one of the building blocks of investing, to determine an investment’s performance. TVM says that a dollar today is worth more than the same dollar in the future due to its earning capacity.

IRR can be used as a forward-looking estimate of the potential future returns of an investment or as a backward-looking measure of the performance of a completed investment. Using it to evaluate the past performance of an investment can be very useful as it captures many different factors and produces a single percent return. However, when used to estimate potential future returns, one should remember that the projected IRR is only as reliable as the underlying assumptions that go into that calculation.

Limitations of Internal Rate of Return as a Predictive Metric

Despite its name, calculating a projected future IRR actually requires one to take into account a number of external factors, which are very difficult to predict. On the surface, the calculation seems simple as it reflects the amount cash that goes into the investment and the amount of cash that comes out of the investment over its life. However, predicting future cash flows often hides large assumptions such as the total project costs, future interest rates, and broader market conditions. These assumptions inevitably involve a great deal of human subjectivity and therefore carry the potential not only for error but also bias.

In other words, by using very optimistic assumptions about the future, it is easy to show a very high projected IRR - while a more conservative approach may dramatically reduce the estimated potential return.

Any experienced real estate investor will tell you that few investments ever go exactly as planned. An investment that requires real construction is particularly vulnerable to large unforeseen changes in budget and timing. Bad weather or permitting delays may push back the schedule by weeks or even months. A sub contractor goes out of business or you find unexpected structural work and the costs can increase quickly. Yet, few investors factor in these sort of unpredictable events into their projections, instead relying on models that assume everything goes as smoothly as possible.

In addition to IRR limitations around predicting future cash flows reliably, there is also the somewhat unrealistic assumption that equally good investments are readily available at all points in the future and that you can effectively have your money working for you 100% of the time.

To illustrate this fallacy, pretend you are evaluating two opportunities: Investment A and Investment B. Investment A is a fully stabilized apartment building that conservatively should pay an 8% dividend (true cash-flow) every year for ten years. Meanwhile, Investment B is a condo development that has a two year projected IRR of 25%. On paper the 25% IRR will beat out the 8% annual return every time - but the 25% IRR is based upon the condo market being strong in two years when the project is completed and also assumed that you are able to find another investment just as good as Investment A for the next 8 years after you make your returns from Investment B. Many first time investors may be quick to choose Investment B, while the experience real estate investor would likely go with Investment A almost every time.

Perhaps the most challenging issue with relying on IRR calculations today comes from questionable assumptions about what future property values will be, something that is particularly impactful for equity investments. Although most investors try to make educated decisions based on past events and their best estimates of the future, history has also shown us that past performance is not indicative of future results. Particularly for longer-term projects, cap rates can fluctuate dramatically over the lifetime of an investment having a large impact on the ultimate future value of a property.

In other words, it is not always safe to assume that the cap rate for a property today will be the cap rate for the property tomorrow.

Real World Example: How Cap Rate Can Impact IRR

Imagine a hypothetical equity investment in an apartment building. Assume the apartment building costs $10M dollars. As the investor, you put up $3M in equity and borrow $7M in debt from a bank. Over the next five years, the apartment building generates net income starting at $200,000/year and grows 3% every year until year 5 when you sell the property. In Scenario A the building is sold at a cap rate of 5.5% (roughly the same as what your purchased it for) while in Scenario B the building is sold at a cap rate of 7%.

Scenario 1 - Cap Rate of 5.5%

Equity Purchase -$3,000,000
Year 1 Income $200,000
Year 2 Income $206,000
Year 3 Income $212,000
Year 4 Income $218,000
Year 5 Income $225,000
Sale $4,100,000
IRR 11%

Scenario 2 - Cap Rate of 7.0%

Equity Purchase -$3,000,000
Year 1 Income $200,000
Year 2 Income $206,000
Year 3 Income $212,000
Year 4 Income $218,000
Year 5 Income $225,000
Sale $1,700,000
IRR -2%

It may seem unlikely to the average investor that stabilized class A multifamily properties, which are selling at cap rates ranging from 4.5% to 5.5% today, could see such a dramatic change in value. However, as recently as 2002 cap rates for the same properties could be anywhere between 6.0% and 7.0%. Just by assuming a shift similar to what we’ve seen in recent history could turn your optimistic 11% IRR into -2% IRR.

Conclusion

As you can see, using IRR to evaluate the potential profitability of an investment generally involves a lot more assumptions than may be immediately apparent. And these assumptions are exceedingly complex and heavily subject to human bias. It’s important to remember that no one can predict the future and all investments carry risk. The best investors are conservative in their assumptions and factor in unexpected negative events. Most importantly, they are not easily fooled by the shiny promise of large IRR’s from those who are most likely to benefit from the short-term sale and have little invested in the long-term accuracy of those projections.

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