Internal Rate of Return (IRR) – Considerations for CRE Investing


Several standards are used by CRE investment managers to assess their pipelines and portfolios. None, however, provides a more immediate indication of a transaction's profitability than the internal rate of return, or IRR. The internal rate of return is a statistic that investors use to determine the rate at which the value of an investment will increase. The IRR, expressed as a percentage, provides a clear lens through which investors may conduct "apples-to-apples" comparisons. In this blog article, we'll discuss what IRR is, how to calculate it, and how to track it.

What is Internal Rate of Return in Commercial Real Estate

The internal rate of return is a sort of discounted rate or discounted cash flow assessment that investors use when evaluating potential commercial real estate investments. Higher IRRs indicate that commercial real estate investments will create higher returns, allowing for a faster return on investment. The IRR is one of the most important bottom-line measures during assessments since it is a direct indication of profitability.

Many investing methods rely on keeping assets for several years, which implies investors must consider returns beyond the following year. Unlike comparable estimates, it takes into account changes in the value of money. The internal rate of return provides a comprehensive perspective via which investors may assess returns over time. This depicts how the value of an investment is expected to develop over time.  

Investors can assess the profitability of various ventures in the pipeline by computing the Internal Rate of Return, then choose one or more to pursue. 

Benefits of Internal Rate of Return or IRR in Commercial Real Estate Investing

  • The IRR is best used as a point of comparison, weighing predicted returns against beginning expenses and other arrangements. The investment is judged worthwhile when the internal rate of return exceeds the firm's goal level, commonly known as the hurdle rate. 

  • Investors combine the internal rate of return with a net present value, which examines cash inflows and outflows. 

Drawbacks of Internal Rate of Return or IRR in Commercial Real Estate Investing

  • IRR is only a forecast. As a result, real returns are susceptible to lease cancellations, fluctuating market circumstances, and other uncontrollable variables.

  • IRR is stated as a percentage. It provides a useful reference point but does not always provide insight into overall income. As a result, investors often use IRR in conjunction with other indicators that produce more specific statistics. 

  • Aside from the IRR, investors must consider other elements such as risk. For example, a significant risk of setbacks and delayed revenue may make one contract less appealing, even if it has a larger IRR.

Limitations and Challenges of IRR in Investment Analysis

Although IRR is a useful metric for assessing the potential return on an investment, investors should be aware of its constraints and difficulties when making financial decisions. We can get a more rounded understanding of the application of IRR in investment analysis by looking at these elements.

1. Time Value of Money (TVM)

The assumption that investment cash flows can be reinvested at the same rate as the IRR itself is one of the main problems with IRR. Given that interest rates and reinvestment opportunities can change over time, this might not always be possible in practice. Reinvestment at the assumed IRR rate could result in an inaccurate representation of actual investment performance.

2. Multiple IRRs and Non-Conventional Cash Flow Patterns

When dealing with non-standard cash flow patterns where there are multiple sign changes (positive and negative) in the cash flows, IRR also has this limitation. It becomes difficult to correctly interpret the results in these situations because the IRR equation may produce multiple solutions or no real solution at all. This can be especially challenging for complicated investments or projects with erratic cash flow.

3. Ambiguity in Decision-Making

Comparing IRR values alone can produce ambiguous results when comparing investments with different cash flow patterns and sizes. The size and duration of the investments can have a significant impact on their overall profitability, so a higher IRR does not always indicate a more profitable investment.

4. Size Bias

Because they can achieve high IRR values due to the compounding effect over a shorter period of time, smaller projects with shorter durations tend to be preferred by the IRR metric. Due to this size bias, investors may overlook bigger, longer-term investments that still generate sizable financial returns despite having a lower IRR. 

5. IRR May Not Capture the Whole Picture

Without taking into account other elements like the size of the investment, the length of the project, or external economic conditions, IRR only considers the time-weighted rate of return. Because of this, it might not offer a thorough understanding of the investment's potential and risks.

6. Sensitivity to Cash Flow Timing

The timing of cash flows greatly affects the IRR metric. Small changes in the timing of cash inflows and outflows can lead to significant fluctuations in the calculated IRR, potentially leading to misleading conclusions about the investment's profitability.

7. The Reinvestment Assumption

The notion that an investment's cash flows can be reinvested at a rate equal to its internal rate of return (IRR) might not be in line with current market conditions or reinvestment opportunities. When interest rates change significantly during the investment period, this assumption may be particularly problematic.

Formulae of IRR for Commercial Real Estate Investment

The formulae for IRR calculation for commercial real estate investment is below

As previously stated, the calculation assumes that the net present value is zero. This is due to the fact that investors must put money down for an investment contract. Investors begin this procedure with pertinent forecasts as well. 

In summary, you determine the internal rate of return by adding the initial cash outlay to the projected inflows for each year. The above equation assumes only three years of data, but you may incorporate forecasts from as many years as you have available.

Example of IRR for Commercial Real Estate Investment

Consider the following example of an internal rate of return computation using two commercial real estate investment deals: P and Q. Deal P required an initial equity investment of $1,200,000. Deal Q required a $2,000,000 commitment. Investors used estimates to account for year-to-year revenue variations for each facility.

Values

Deal P

Deal Q

Initial Cost of Capital

1,200,000

1,200,000

Cash flow of 1st year

379,000

440,000

Cash flow of 2nd year

402,000

452,000

Cash flow of 3rd year

396,000

465,000

Cash flow of 4th year

404,000

459,000

Cash flow of 5th-year

410,000

467,000

Internal Rate of Return (IRR)

19.391%

4.537%

 

We can see from the data above that commercial real estate deal P has an IRR of 19.391%. Commercial real estate deal Q offers an IRR of 4.537%. 

Commercial real estate Deal P is the most profitable choice based only on the IRR. Having said that, investors rarely examine IRR in isolation. They often consider statistics, risk concerns, and other aspects that may push them to choose one deal over another before making a choice.

IRR Vs ROI Vs CAGR of Commercial Real Estate

Financial metrics used to quantify performance of commercial real estate investments include internal rate of return, return on investment, and compound annual growth rate. They achieve this in different ways, though. 

Internal Rate of Return (IRR)

Rate of Interest (ROI)

Compound Annual Growth Rate (CAGR)

  • The IRR is a percentage.


  • It reflects a commercial real estate investment's profitability over time, with cash flows altering each year.
  • The ROI calculates the overall growth of the commercial real estate investment from beginning to end.

  • ROI does not account for variations in returns from year to year. 

  • It provides a useful picture of growth.

  • But it may not always be useful for long-term assessments or forecasts. 
  • The CAGR of a commercial real estate investment is calculated over a certain time period.

  • It takes into consideration compounding values.

  • However, it only considers the investment's initial and ending values.

  • CAGR does not take into consideration fluctuating returns over time.

 

NPV vs. IRR

Metric

Net Present Value (NPV)

Internal Rate of Return (IRR)

Definition

Measures the difference between the present value of cash inflows and outflows over a given time period, discounted at a specified rate.

Represents the discount rate at which the net present value of cash inflows equals the net present value of cash outflows.

Purpose

Evaluates the absolute profitability of an investment in monetary terms.

Assesses the annualized rate of return of an investment.

Decision Criteria

If NPV > 0, the investment is considered profitable. If NPV < 0, the investment is considered unprofitable.

If IRR > Discount Rate, the investment is considered profitable. If IRR < Discount Rate, the investment is considered unprofitable.

Suitable for

Useful when comparing investments with different sizes or durations.

Suitable for comparing investments with similar sizes and durations.

Limitations

May not consider the scale of investment or duration, leading to potential inaccuracies in comparing large and small projects.

May have multiple IRRs or no real IRR in some investment scenarios, making interpretation complex.

Focus

Emphasizes the monetary value of an investment.

Highlights the annualized rate of return of an investment.

 

To further contrast NPV and IRR, let us take a fictitious case study into consideration. Investment A and Investment B, each requiring a $1,000 initial capital outlay, will be the subject of our analysis. 

Over a five-year period, the cash flows for each investment are as follows:

Year

Investment A

Investment B

0

-$1,000

-$1,000

1

$300

$200

2

$300

$300

3

$300

$400

4

$300

$500

5

$300

$600

Calculations for NPV

Assuming a discount rate of 10%, let's calculate the NPV for both investments:

For Investment A: NPV = (-$1,000) + ($300 / (1 + 10%)^1) + ($300 / (1 + 10%)^2) + ($300 / (1 + 10%)^3) + ($300 / (1 + 10%)^4) + ($300 / (1 + 10%)^5)

For Investment B: NPV = (-$1,000) + ($200 / (1 + 10%)^1) + ($300 / (1 + 10%)^2) + ($400 / (1 + 10%)^3) + ($500 / (1 + 10%)^4) + ($600 / (1 + 10%)^5)

Calculating the NPV for both investments yields:

For Investment A: NPV ≈ $41.56 For Investment B: NPV ≈ $163.59

Both Investment A and Investment B have positive NPVs, indicating that they are expected to be profitable. However, Investment B has a higher NPV, suggesting it is likely to generate higher monetary returns.

Calculations for IRR

To calculate the IRR for both investments, we set the NPV equal to zero and solve for the discount rate:

For Investment A: 0 = (-$1,000) + ($300 / (1 + IRR)^1) + ($300 / (1 + IRR)^2) + ($300 / (1 + IRR)^3) + ($300 / (1 + IRR)^4) + ($300 / (1 + IRR)^5)

For Investment B: 0 = (-$1,000) + ($200 / (1 + IRR)^1) + ($300 / (1 + IRR)^2) + ($400 / (1 + IRR)^3) + ($500 / (1 + IRR)^4) + ($600 / (1 + IRR)^5)

Calculating the IRR for both investments using financial software or Excel, we find:

For Investment A: IRR ≈ 12.9% For Investment B: IRR ≈ 16.9%

The IRR represents the annualized rate of return that each investment is expected to yield. Investment B has a higher IRR than Investment A, indicating it has a higher potential annual return on investment over the investment period.

Case Study: The High Line - Transforming Abandoned Rails into Urban Oasis

Imagine an outdated railroad track that has been left in the city of New York. A group of forward-thinking investors recognized the opportunity to give this vacant space new life and make it into something truly remarkable. They started a ground-breaking project that cost $150 million overall and was expected to generate an impressive Internal Rate of Return (IRR) of 15% over the course of the investment.

The High Line, an iconic urban park constructed on a former elevated rail line on Manhattan's west side, is the inspiration behind this bold project. The park has come to represent creative city planning and profitable commercial real estate ventures.

The investors understood right away that The High Line had the potential to transform into a unique urban green space for the city. In the midst of the urban chaos, they envisioned creating a tranquil oasis that would draw both locals seeking a break from the concrete jungle and visitors looking for a distinctive New York experience.

IRR Utilization by EquityMultiple

IRR calculations were carefully used by the investors to evaluate the project's potential returns and associated risks throughout The High Line's development. They took into account a number of variables, such as the price of development, the cost of operations, and the anticipated income from rising property values near the park.

The investors learned a lot about the project's financial viability by using IRR as the main metric for evaluation. As a result, they were able to make wise choices and maintain their intended course of action.

Limitations of Real Estate Investing's IRR Metric

Even though IRR is a useful tool, The High Line's success extended beyond monetary gains. Even though the projected 15% IRR was impressive, the project's effects went well beyond numbers.

Overall Yield

The true success of The High Line lay in its ability to turn an abandoned railroad into a green space in the city. The surrounding neighborhood underwent a renaissance as it grew into a vibrant public park. Property values increased dramatically, bringing in new businesses and residents and revitalizing the neighborhood's sense of community. 

The High Line project's total yield was too large to be fully captured by IRR. It included not only the monetary gains but also the community's social, cultural, and aesthetic advantages. The park has gained notoriety as a famous landmark that represents the advantages of imaginative urban planning and the effects of prosperous real estate development.

Bottom Line

You now have better knowledge of the Internal Rate of Return or IRR via the two commercial real estate deals. IRR is useful for assisting in the measurement of the profitability of commercial real estate investments. But, it is not ideal to directly express absolute profitability, cash flow profile, and risk. It must get used in conjunction with others to evaluate commercial real estate investments.

Assetmonk is a notable alternative investment platform in the US that provides a range of investment opportunities. Among these offerings is the Labrea Series A, which presents an assured Internal Rate of Return or IRR of 18% and an expected IRR of 20%. These IRR figures are mentioned in the investment documentation to aid investors in assessing potential commercial real estate investments. By including relevant IRR measures, Assetmonk aims to provide investors with valuable information for a more comprehensive analysis of their investment options.

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FAQs

Q1. What is the internal rate of return in commercial real estate?

A. The internal rate of return is a sort of discount rate or discounted cash flow assessment that investors use when evaluating potential commercial real estate investments. Higher IRRs indicate that commercial real estate investments will create higher returns, allowing for a faster return on investment. The IRR is one of the most important bottom-line measures during assessments since it is a direct indication of profitability.

Q2. How do you calculate the internal rate of return in real estate?

A.  You determine the internal rate of return by adding the initial cash outlay to the projected inflows for each year. 

Q3. What is a good internal rate of return for real estate?

A. An 18 percent to 20 percent is a good internal rate of returns for commercial real estate.

Q4. What is 20% IRR?

A. A 20% IRR indicates that an investment should provide a 20% yearly return throughout the life of the commercial real estate investment.

Q5.  What if IRR is greater than 0?

A. An IRR greater than 0 indicates that your commercial real estate investment is profitable even after future income inflows are discounted to reflect the fact that $1 gained now is worth more than $1 earned tomorrow.

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