Real estate sponsors will often present Internal Rate of Return (IRR) as the main metric to consider when evaluating an investment opportunity. It is important to be aware of the drawbacks and benefits of all the various metrics used to present a real estate investment opportunity including cap rate, equity multiple and IRR among many others. I hope the post helps you as you navigate these metrics.
An IRR is a financial metric commonly used to evaluate the profitability of a real estate investment opportunity. It measures the annualized rate of return that an investor can expect to earn on their investment, taking into account the timing and size of cash flows and often the eventual sale of the asset as well.
Here are three benefits of using an IRR to analyze a real estate investment property, as well as three drawbacks:
1. IRR provides a holistic view of a property’s profitability: The IRR takes into account the timing and size of both positive and negative cash flows associated with a property. This allows investors to get a more complete picture of the property’s profitability over time, rather than just looking at the upfront purchase price or the property’s expected rent or sale price.
2. IRR allows for comparison of investments: By expressing the expected return on an investment as a percentage, the IRR allows investors to compare the profitability of different real estate investment properties. This can be particularly useful when deciding between multiple potential investment opportunities.
3. IRR takes into account the time value of money: The IRR takes into account the fact that a dollar received today is worth more than a dollar received in the future. This is because money received today can be invested and earn a return, whereas money received in the future cannot. As a result, the IRR provides a more accurate representation of an investment’s profitability.
1. IRR assumes reinvestment of cash flows: The IRR calculation assumes that all cash flows from the investment property will be reinvested at the IRR rate. This may not always be realistic, as investors may need or want to use some of the cash flows for other purposes.
2. IRR does not consider the risk of an investment: The IRR does not take into account the risk associated with an investment. This means that an investment with a higher IRR could still be less attractive if it carries a higher level of risk.
3. IRR can be sensitive to small changes in assumptions: The IRR is calculated based on a series of assumptions about the timing and size of cash flows. As a result, small changes in these assumptions can lead to significant changes in the IRR. Sponsors that provide the IRR often the make predictions into and assumptions about future events such as rent growth and sale price that take into consideration the best-case scenario outcome. Should that best case scenario not come to pass the IRR may be, in actuality, substantially lower. This can make it difficult to accurately compare the profitability of different investment properties.
Overall, IRR can be a useful tool for analyzing the profitability of a real estate investment property. However, it is important to consider the pros and cons of IRR as a measure of the strength of an investment opportunity, and to use it in conjunction with other financial metrics as well as all risks associated with the investment to get a complete picture of an investment’s potential returns.