All You Need to Know: Internal Rate of Return (IRR)

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What is it?

IRR, or Internal Rate of Return, is the most commonly used profitability metric in commercial real estate.

Why is it so popular?

Unlike other return metrics, IRR takes into consideration both cash flow and time value of money. It can be used to compare two investments with varying timelines.

How is IRR calculated?

A project’s internal rate of return is equal to the calculated discount rate when the net present value of an investment’s future cash flows is zero. Because of the nature of the formula, IRR cannot be calculated analytically. Rather, it must be calculated through trial and error or with software. Sorry folks – there isn’t an easy formula for IRR.

Can IRR be manipulated?

Yes, and it commonly is. Because IRR takes into consideration time value of money, it can be inflated by reducing the length of an investment or delaying the start of an investment.

When a private equity manager creates a fund, they typically ask for commitments before they “call” the investment dollars. On the commitment date, an investor must be ready and able to wire monies to the fund. However, fund managers typically calculate the IRR based on the the call date – shortening the timeline of an investment, increasing the IRR.

Should I base my investment decisions on a project’s IRR?

Not entirely. A project’s IRR captures the profitability piece of the investment puzzle. You should also consider the risk associated with an investment opportunity. In commercial real estate, risk is commonly measured using the debt service coverage ratio and loan to value.

Also consider other profitability metrics like yield (cash on cash return) and equity multiple.

Written by Bullpen Editors
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