One of the most important and widely used metrics for evaluating the performance of commercial real estate properties is the internal rate of return, or IRR. While it’s a vital piece of the puzzle, it can also be manipulated in a way to misrepresent the results of the calculation.
What is IRR?
In simple real estate terms, IRR is the average annual return an investment property is expected to generate. This percentage is calculated by factoring in the property’s future cash flows and proceeds from its eventual sale.
The basic premise of IRR is to take into account the time value of money through a discounted cash flow analysis (think of it as compound interest in reverse). The concept of time value of money states that a dollar today is worth more than a dollar tomorrow because of inflation and opportunity cost. Money received today can be invested and potentially generate a return making its overall value greater; receiving the same amount at a later date means you would forgo the potential returns received in the meantime.
How is IRR Calculated?
The IRR calculation is highly complex and requires four main components:
- The initial investment amount
- Annual cash flows (net of any debt service)
- Duration of the investment
- Eventual sale price of the property
How is IRR Used?
Because cash flows vary between investments and are generated over a period of time, they don’t have an equal relative value. IRR is used to evaluate and compare investment opportunities through percentages rather than just the total amount of income generated, creating more of an “apples-to-apples” comparison. Because cash flow varies and is spread across different periods in the future making it difficult to compare, IRR derives the present value of future income by appropriately weighting cash flows – cash flows closer to the beginning of the investment period are weighted higher than cash flows towards the end.
The table below shows a simplified comparison between three different properties. Each investment has total cash flows of $5,000 but they are spread across the investment period differently. This example illustrates that income produced sooner results in a greater IRR, as is the case with Property B. Property C has a lower IRR than Properties A and B, despite each of the example investments returning $20,000 because cash flow occurred much later with Property C.
Note: “Year 5” includes both the cash flow for the year and income from the sale of the property.
Advantages and Drawbacks
Evaluating real estate investments using IRR is useful because it factors in the time value of money and appropriately weights cash flows while being relatively simple to calculate (when appropriate software is used).
An accurate and final IRR can only be calculated once an investment is sold. The initial IRR is an estimate based on certain assumptions – amount of cash flow per year, when the property will be sold and the sale price of the property. Because it is based on assumptions (who would have imagined five years ago that a pandemic would disrupt the entire economy and impact real estate values), projections can be misleading and overly optimistic. It is vital to analyze how valid the underlying assumptions are in an IRR calculation and not make an investment decision based solely on an advertised attractive IRR.
IRRs are just like any other estimates and the actual outcomes can differ greatly from projections. Given its inherent subjectivity, a property’s IRR should only be one variable when making investment decisions. Instead of relying only on a “high” IRR to deem an investment opportunity as worthwhile, consider factors like the size of the project, how long the holding period is, what potential risks may occur that are not being taken into account in an advertised IRR and the actual amount of profit that will be realized. When used in conjunction with other evaluation measures, IRR is an important piece of the real estate investment opportunity puzzle.
The views and opinions expressed in this commentary reflect Modiv Inc.’s (together with its affiliates, “Modiv”) beliefs and observations in commercial real estate as of the date of publication from sources believed by Modiv to be reliable and are subject to change. Modiv undertakes no responsibility to advise you of any changes in the views expressed herein. No representations are made as to the accuracy of such observations and assumptions and there can be no assurances that actual events will not differ materially from those assumed. The forward-looking statements in this paper are based on Modiv’s current expectations, estimates, forecasts and projections, and are not guarantees of future performance. Actual results may differ materially from those expressed in these forward-looking statements, and you should not place undue reliance on any such statements. These materials are provided for informational purposes only, and under no circumstances may any information contained herein be construed as investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any Modiv program or offering. Alternative investments, such as investments in real estate, can be highly illiquid, are speculative, may not be suitable for all investors, and there is no guarantee that distributions will be paid.