Along with other metrics such as the capitalization rate (cap rate) and equity multiple, the target internal rate of return (target IRR) is a widely used measure in the real estate industry for evaluating the potential profitability of an investment property. Unlike the regular IRR, a target IRR is typically expressed as a range, allowing for flexibility in adjusting strategy as market conditions change. For example, a target IRR for a real estate investment might be 15-20%, indicating a targeted return of between 15% and 20% on the investment over the holding period.
Target IRR vs. Single Point IRR
Like a regular IRR, the target IRR is calculated using the property’s cash flows, including the initial investment and any additional investments made during the holding period, as well as the length of the holding period and a future sale price. Most people use a financial calculator or a spreadsheet program with a built-in IRR function to calculate the IRR. First, they enter the initial investment and the cash flows for each period, usually on a monthly or annual basis. Then, they specify the length of the holding period. The calculator or spreadsheet will then calculate the IRR based on the cash flows and the holding period. Sponsors will then do this for several potential scenarios, from best case to worst case, to come up with a range for the IRR and create the target IRR. This range, compared to a single point IRR, is especially useful for a limited partner (LP) investor, as it takes into consideration multiple scenarios rather than just the best case scenario often represented by a single point IRR.
Importance of the Target IRR
The target IRR is important for several reasons. It helps investors evaluate the potential return on their real estate investment and compare the relative attractiveness of different properties. It is also important to consider the factors that went into calculating the target IRR, such as the risk profile of the property, the expected cash flows, and the length of the holding period and future sale price. However, it is important to keep in mind that the target IRR is just one factor to consider when evaluating a real estate investment opportunity. Other factors such as location, condition, tenant base, and potential for appreciation are also important. Additionally, the target IRR is based on assumptions about the property’s future cash flows, including projected rent growth and a future sale price, that may not be accurate due to the unpredictable nature of future market conditions.
In summary, the target IRR is a useful tool for evaluating the potential return on a real estate investment. It represents the annualized return that an investor can expect to earn on the investment over a period of time and can be used to compare the relative attractiveness of different properties. However, it should be used in conjunction with other factors and is based on assumptions that may not be accurate.