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Dissecting an IRR: A Quick Way to Assess Investment Risk

by Brad Johnson on April 22, 2014 · 5 comments

  
Internal Rate of Return

When considering various real estate investment options, it’s tempting to just pick investments that offer the highest pro forma IRR (aka the discount rate that would make the present value of a series of cash flows equal to zero; which is a fancy way of saying an investment’s total return). While I imagine there are worse investment strategies, you can’t simply compare a 16% IRR to a 15% IRR and simply declare the former investment the winner. I wish it was this easy, but unfortunately real estate investing is more nuanced than that.

What appear to be equivalent returns can be wildly different. What I mean is that one investment’s 15% IRR is not necessary equal to another investment’s 15% IRR. The difference between the two returns is due to the inherent risk of one investment relative to the other.

IRRs Do Not Account For Risk

Real estate investment risk can come in many forms, including:

  • Market risk – lack of tenant demand
  • Sponsor risk – failure to execute business plan
  • Physical risk – unforeseen structural problems
  • Capital markets risk – interest rate spikes, credit crunch

Each of these risks deserves its own article and must be evaluated carefully before making an investment. However, I’d like to focus on the last bullet point, capital markets risk and specifically, how it relates to an investment’s IRR projection.

Related: Introduction to Internal Rate of Return (IRR)

IRR Component Calculation - A Quick Way to Gauge Investment Risk

You can quickly assess an investment’s exposure to capital markets risk by separating the two components of an IRR calculation, which are 1) the asset’s monthly or yearly distributable cash flow and 2) the net proceeds from a sale.

An investor can segment these IRR components by calculating the following:

  • The present value (PV) of the yearly cash flows
  • The PV of the sale proceeds
  • The PV of the overall investment

Dividing each present value component by the investment’s overall PV would give you an indication of how much the investment’s success hinges on either the cash flow or the sale price. For example, if a (non-flip) real estate investment’s net proceeds from sale contributed 80%+ plus to the project’s overall PV and thus its IRR, you might want to take a closer look at the residual sale assumptions (i.e. the exit cap rate and timing of the sale). Reason being, it’s impossible to predict future sale prices.

To accurately predict a market cap rate into the future you would need to correctly forecast forward interest rates, investor risk tolerance and market sentiment toward real estate during the sale year – good luck with that. If I could correctly predict these metrics, I probably wouldn’t bother investing in real estate – I’d be aboard a yacht in some exotic locale making a killing trading the futures markets for about 10 minutes a day. If a real estate investment professional tells you he knows what the market cap rate will be 5+ years in the future, run the other direction.

However, if an investment’s IRR component split was closer to say 60% from sale / 40% from cash flow you might be less concerned with trying to pinpoint the future sale price. This investment would have more margin for error on the exit and would likely carry less risk, as – generally speaking – it’s easier to predict stabilized cash flow returns than exit cap rates. This is especially true if the investment has contractual leases or provides affordable shelter, as demand for your product is fairly constant.

Related: What is a Cap Rate? (Capitalization Rate)

Cap Rates Likely to Rise – How “Sensitive” is Your IRR?  

Partitioning the IRR will give you an idea of how sensitive the investment’s return projections are to fluctuations in the capital markets. While market cap rates are not perfectly correlated to interest rate fluctuations, they certainly rise when interest rates spike. Interest rates really only have one way to go from today’s rock bottom levels; consequently, investors should be wary of longer term investments that completely hinge on a successful exit.

The safer path is to choose investments that offer higher ongoing cash on cash returns. This is why my investment company loves high cash flowing real estate investments – they are easier to analyze and value, more likely to achieve our lofty return goals, and more resilient to outlier events and recessions.

Just remember IRRs are not absolute. Real estate investors should be mindful of what’s behind IRR curtain when making investment decisions.

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{ 5 comments… read them below or add one }

J Scott April 22, 2014 at 1:58 pm

Brad –

Great article! You’re absolutely correct that too many investors presume that their assumptions going into a deal will hold true, and they fail to analyze the potential risks if one or more of those assumptions don’t pan out. Nobody likes to think about risk modeling (okay, most normal people don’t :), but as your investments get bigger and longer-term, that analysis becomes more and more important.

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Eric April 22, 2014 at 9:26 pm

“Market risk – lack of tenant demand” can be mitigated by price. Demand can always be increased by lowering price, or increasing marketing.

A large risk is not knowing if you are buying into a ‘D’ class neighborhood that looks great on paper, but only cash flows like a ‘B;’ class neighborhood.

Or getting a C or B property, and moving ‘D’ tenants into it. If you do not understand how to screen tenants, you risk is going to be a lot higher, and your IRR will suffer greatly.

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Jeff Brown April 22, 2014 at 9:49 pm

Devil’s Advocate — ” . . . and more resilient to outlier events and recessions.”

The higher the cap rate, the lower quality the neighborhood, and subsequent tenant quality. My experience is that in recessions and most ‘outlier’ events those neighborhoods suffer sooner rather than later, and most, especially as it relates to employment.

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Mehran Kamari April 23, 2014 at 5:15 am

Great article Brad! Makes me feel good about focusing on high cash flow investments:)

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Sharon Tzib April 23, 2014 at 10:30 am

Excellent points, Brad!

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