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The Internal Rate Of Return: Is It Really As Foolproof As We Thought?

by David Rodriguez on May 24, 2014 · 7 comments

  
Internal Rate Of Return

I recently had a conversation with an investor that was relying on their internal rate of return when considering an investment.

While I find the IRR to be a weak tool in general, the most pressing concern during this conversation was the reinvestment rate assumption that is embedded in the internal rate of return calculation.

Related: Introduction to Internal Rate of Return (IRR)

The Problem With Taking The Internal Rate Of Return At Face Value

The investor produced a spread to me and, with the utmost certainty, stated that the internal rate of return on the parcel was over 19% and that since this was greater than what his return in the stock market was last year this was a better move.

What is the problem with such a comparison?

Not only is there a time span problem but the reinvestment rate assumption embedded in the internal rate of return calculation tend to inflate the IRR. In other words the 19% cannot be compared to a realized return in the stock market.

In plain terms if we calculated an IRR of 19% for a 5 year project the reinvestment rate assumption means that every cash flow received over the investment period is assumed to be reinvested at 19%.

To simplify, if we assume that the annual cash flows received are $1,000 for each of the 5 years this would mean that the IRR assumes that every one of those $1,000 cash flows received will be reinvested at 19%.

What is the problem with this? What is the likelihood that you can actually reinvest those cash flows at a rate of 19%?

Can you guarantee that when you receive the $1,000 in year 4 that you will be able to locate an investment at 19%?

We can’t even guarantee returns over a one year period yet when we use the IRR we are working off of an assumption that we will be able to reinvest cash flows over the length of a project at the calculated IRR.

To be clear if we were simply comparing two similar parcels with similar risk characteristics we can still use the IRR. This isn’t because I find it to be a good tool but instead because it at least ensures that you are comparing apples to apples so the assumptions are at least constant. . . .even if flawed.

Conclusion

The idea that I am trying to convey here is that the IRR is not foolproof and that it cannot just be compared with other returns because of the embedded assumptions.

The other point I am trying to convey is that an investor will never achieve the calculated internal rate of return unless they are able to reinvest all cash flows at the computed internal rate of return.

Related: Dissecting an IRR: A Quick Way to Assess Investment Risk

In the example above where the investor calculated an internal rate of return of 19% it is highly unlikely that he would have found 19% investments to reinvest cash flows in over the project life.

In the worst case if he found no other investment and held the cash flows in cash earning 0%, the 19% internal rate of return would be substantially reduced. In this particular example the rate dropped to 11%.

This is just one specific example of why it may not be possible to rely on any one metric and to have a fair understanding of whichever metric you decide to be superior.

Do you agree with me?

Be sure to leave your thoughts and comments below!

 

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{ 7 comments… read them below or add one }

Craig May 24, 2014 at 12:08 pm

Agree on the reinvestment rate assumption of IRR. However, as you say, if you can express everything on consistent basis such as IRR, then you can use it to rank your investment choices on a relative basis. For me personally I think it’s best to create your own spreadsheet model and customize the rates at which you think you can reinvest the cash flows you get back (either assuming some low conservative flat rate, or backing out future rates implied by some yield curve).

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Robbie May 25, 2014 at 9:36 pm

David –

This is an excellent, and often overlooked point. I actually love the IRR (I like to use the XIRR function in Excel) as I believe it is the only true, all-in, apples-to-apples return calculation that can be used to compare across investment classes. But that hardly makes it a substitute for common sense and well-thought out assumptions.

The incredible power of compounding is limited in real estate if we do not reinvest cashflow into properties that give us the same COCR return (or better). Without compounding the initially outsized returns suddenly appear quite similar to broad stock market returns.

In your example an investor could mitigate the risk of not finding good future deals by setting an IRR floor through “snowballing”. Rather than let the cashflow dollars sit idle at 0%, the investor could reinvest them into the principle of the property thus cutting down the time component in the IRR equation. Depending on the actual cashflow, costs, mortgage, etc, the extra payments from cashflow would allow the investor to attain something on the order of a 14-17% Compounding return (IRR) rather than the 11% if the cash sits idle.

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Craig May 26, 2014 at 6:11 am

Robbie,

That is a great tip. If there are no reinvestment opportunities one could always simply pay down the mortgage more quickly, thereby reducing interest expense and thus improving the overall return profile.

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Shaun May 26, 2014 at 11:58 pm

This makes some great points.
Many people will look at a fancy equation that some very smart person came up with and just follow it without question.
The inherent flaw of the reinvestment rate is a prime example of why one must truly understand what the formulas mean to be able to garner the most useful data from them.

Beyond that any of these formulas will follow the GIGO rule. The answers you get are only as good as the inputs you make into it. That is really the downfall of most financial projections and forecasts of any sort. It is just REALLY hard to accurately predict what the future earnings will be.

In the case of real estate you need to accurately predict each monthly cash flow for the entire hold period (Which will NEVER happen as even if you have your average cash flow nailed to the penny, unless you know WHEN you will have the 4% vacancy and the 2-3 repairs that added up to 5%, etc.) and then accurately predict what you will be able to sell it for at the end, and exactly when that will happen.
Good luck with that! :)

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Nathan June 1, 2014 at 5:55 am

Makes a lot of sense; but that’s why the modified internal rate of return is so useful. It eliminates the assumption that you’re able to reinvest at the IRR and instead lowers that assumption to one’s discount rate which should be equal to your next best investing option.

Personally I look at all the major metrics, but tend to focus on the MIRR and the NPV of the deal.

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Shaun July 11, 2014 at 2:07 pm

People like to see percentages.

I don’t do this as it isn’t worth the effort for the deals I generally am doing, but I think the best way to evaluate a potential deal is to calculate the NPV discounting at your WACC.

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Shaun July 11, 2014 at 2:08 pm

Oops posted this to the wrong article, though it is related. :)

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