# The Definitive Guide to IRR (Internal Rate of Return)

by on July 8, 2014 · 24 comments

The most easily understood metric of investment return in real estate is Cash on Cash Return, usually abbreviated either CCR or COC.  The concept is rather simple – CCR juxtaposes the cash investment that has been made to the Cash Flow (Income minus Expenses) being received.

For example, let’s say you invest \$100,000 cash to buy a 4-plex which generates \$2,000/month of Gross Income which results in \$1,200/month of Cash Flow.  Since CCR is usually thought of in terms of annual return, we must multiply all of the monthly numbers by 12.  Thus, this \$100,000 4-plex is generating \$14,400 of Annual Cash Flow.

Now, CCR is simply the answer to the question – if I invest \$100,000 in this 4-plex, how quickly, or at what rate, would I recover my cash?

Framed in this way, all we basically aim to find out is what percentage of \$100,000 does \$14,400 represent.  In mathematical terms, if \$100,000 is 100%, then \$14,400 is x – at which point we solve for x:

X (CCR) = \$14,400 / \$100,000 = 14.4%

Thus, having paid \$100,000 and received \$1,200/month of Cash Flow, our achieved CCR is 14.4%.

I’ll segue for just a sec, even though this doesn’t particularly have bearing on today’s discussion, but it is timely to point out that leverage obviously has the effect of improving the CCR.  For example, let’s just say that in lieu of paying \$100,000 cash for this 4-plex, you instead make a down-payment of 25% (\$25,000) and finance the rest.

In this case, the presence of a note for \$75,000 would require a monthly payment – let’s just say \$450/month.  This extra expense would have the effect of lowering your Cash Flow from \$1,200/month to \$750, or \$9,000 per annum.  But, what does this look like in terms of the CCR?

Well – the thing to remember is that while the cost of your investment is still \$100,000, the actual cash investment to you is only \$25,000 in this case.  Thus, what percentage of \$25,000 is \$9,000?

CCR = \$9,000 / \$25,000 = 36%

Related: How to Really Calculate Cash Flow on Your Next Rental Property

## Infinity ROI

Indeed – the less money you have in the deal, the higher the Cash on Cash Return.

And if we follow this path of thought far enough, we would realize that any return on investment of \$0, no matter how small, is actually infinity ROI.  Yes – it’s true; if you managed to purchase this 4-plex with 100% financing, without putting any money into the deal, then even if you were only earning \$100/month of cash flow, it is still a return on investment of zero – infinity.

This is the neighborhood where I’ve lived for the past decade and how I’ve bought everything that I own.

Having said this, I must warn you to please not go out and buy a fully financed 4-plex if the extent of your cash flow will be \$100; doing so will put you one leaky faucet away from not having the money to keep afloat.  However, it is indeed possible to buy with no money down and this represents the single greatest advantage of real estate as an investment vehicle.  But I’ve strayed, so let’s get to the IRR…

## Limitations of CCR Which Are Corrected With IRR

CCR has some inherent to it limitations which render it inaccurate for the very sophisticated investors.  When very sophisticated investors evaluate investment opportunities, they must assign value to things like time value of money and opportunity cast, not to mention that any movement of cash in or out of the transaction significantly impacts the returns, this can not be addressed by simply considering the IRR.  Let’s talk about these one at a time:

## Time Value of Money

Time Value of money is simply the reality that money is more valuable today than at any time in the future.

Related: Apartment Building Investment and the Time Value of Money

There are many economic reasons for why this is true, but it all comes down to the concept of buying power and erosion thereof over time due to inflation of the currency supply and the resulting price inflation.  Currency held today does indeed store more buying power that it will in the future – this statement is almost always true.

With this in mind, the sophisticated investors have to price this erosion of value into their return.  Let’s say that over a set period of time a given investment produces Cash on Cash Return of 12%.

But, in the same period the inflation clocks in at 3%.  On the day the money was vested, it had buying power equal to 100%, but on the day the return was dispersed the buying power is only 97%.  This has to be accounted for, and the IRR formula does exactly that, while CCR does not.

## Opportunity Cost

As they say, there’s a right place and the right time to do everything.

So, if you invest the money now and lock it in for a set period of time, what other, and perhaps better, opportunities might come along that you will not be able to take action upon because your money is locked in…?

For sophisticated investors this is an ongoing problem.  For example, I bring to them my syndicated apartment building.  It looks good today, but what if someone else brings them a deal tomorrow that’s better?  What is the premium ROI that they expect to receive with me today in order to be willing to tie-up funds for a period of time…?

IRR formula addresses this as well.

## Movement of Money

Finally, having weighted the opportunity for time value of money and the opportunity cost, IRR also is able to track movement of cash in and out of investment by tagging each movement with a date.

For instance, having purchased an asset, you might receive cash flow for two years, and then you might choose to refinance the building, which would constitute a large waterfall event.

Later, however, you realize that you were too aggressive on your refinance, leaving your DSCR too low, which result in your cash flow being unable to support the CapEx.  Now you have to dip into your pocket to pay for the repairs, which naturally adversely impacts your IRR.

Once this happens, you decide to sell the building.  And, since there are so many idiots chasing yield in the marketplace, you actually manage to sell a money-loosing asset at a profit – so you add that profit into the IRR.

## Conclusion

The formula for IRR is rather complex, and I’ll let the mathematicians worry about why it works and how.  I simply use an excel spreadsheet to line-up and time-tag all of the in-flows and out-flows, and the formula calculates the return.

Perhaps some visuals or even a little video would be useful here.  But, I’m busy – may be next time.  I’ll simply tell you that to an individual investor buying long-term hold a 10% – 12% IRR might be quite respectable.  In terms of syndications, however, we shoot for mid-teens to make opportunities attractive to the partners.

RelatedIntroduction to Internal Rate of Return (IRR)

That’s hard to find indeed!

What metric of real estate investing do you find most difficult to understand?

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Vamsi July 8, 2014 at 2:13 pm

Wow this is great. I had just read about IRR in a book and was having trouble understanding the concept from the Wikipedia article, but this definitely cleared it up Thanks!

Ben Leybovich July 8, 2014 at 6:02 pm

Haha – I don’t think that whoever wrote the wikipedia article ever used the IRR – that’s what happens a lot…lol

Thanks so much Vamsi!

Roberto Reyna July 8, 2014 at 2:40 pm

Yes, Please Ben try to find some time to make a video on this specific subject, some of us would greatly appreciate your time, thank you in advance.

Ben Leybovich July 8, 2014 at 6:05 pm

Roberto – I’ll see what I can do perhaps in the future

Thanks so much!

Brandon Turner July 8, 2014 at 5:39 pm

Good stuff Ben. I know I need to do more with IRR, including adding it to the BiggerPockets Rental Property Calculator soon!

Ben Leybovich July 8, 2014 at 6:09 pm

Yeah – I’d have to teach it to you first

James Evertson July 8, 2014 at 9:24 pm

My understanding of IRR is that is assumes returns are reinvested at the rate of IRR and this isn’t always feasible. Then again if you’re using it to compare 1 project to another it’s a wash right?

Great post though; IRR is a widely used concept that would behoove most to understand even at a basic level.

Ben Leybovich July 9, 2014 at 6:52 am

James – yes, continual re-investment would be nice, and we try our best to provide this. But, this is easier said than done

Thank you so much for reading and commenting!

Cedric July 8, 2014 at 11:04 pm

Ben
Fantastic information, as a novice investor it was a concept
informative piece.

Ben Leybovich July 9, 2014 at 6:53 am

You are welcome Cedric.

Thanks indeed for leaving a comment!

Paul Lopez July 9, 2014 at 6:48 pm

The IRR is the discount rate by the net sum of all future discounted cash flows less initial investment equals zero. Would you include in the model adjusting the pro forma of the cash flows to account for capital investments (-CF) in future years? And, wouldn’t we also adjust NOI to account for increasing rents during those years? For example, year 0, you have an initial investment of \$100,000 (Cf0=-100,000), then in year 3 say you have to replace the building roof for \$40K, (Cf3=CF3-40,000). I think some people include those future capex expenditures in their IRR calculations. What do people think?

Ben Leybovich July 9, 2014 at 10:03 pm

Haha Yes and Yes Paul. Besides, IRR is easily manipulated through refinancing, cash-outs, and by other means. We should never underwrite to IRR, and LPs should never really deploy capital based on IRR. A deal is good because discounted cash flows say so, not because of the IRR. That is a sort of catch 22 – sophisticated investors want to see the IRR, but that’s not where the magic is

Jeff Brown July 10, 2014 at 10:50 am

Hey Ben — When I used to teach analysis to other pros, IRR was always integral. The first thing out of my mouth was the false and misleading assumption in virtually every IRR analysis. This is especially true today. Here’s what I mean.

A syndication shows an IRR of 15%. Much of it is based on the foundation of impressive annual cash flow. Once a property ‘throws out’ a dollar of cash flow, by definition that dollar is NO LONGER ‘internal’. In fact, it’s now out in the cold, lucky to make 1% at the bank. So, to the extent cash flow is a relatively large part of any investment, the IRR becomes more than somewhat misleading.

The way to eliminate that mirage of 15%, and mirage is being kind, is to bring cash flows ‘forward’ each year at the actual market rate of return. In my experience doing IRR analyses before tax is of no value, so cash flows would then be brought forward at a rate of 1% minus the projected tax hit. In an investment leaning heavily on cash flow for IRR, that 15% would be significantly reduced, but would at least then be far more accurate. Though calculating an IRR takes some doing, computing what used to be called a FMRR (financial management rate of return) now referred to as MIRR (modified internal rate of return). The modified return, especially in for properties generating impressive cash flows, will virtually always be less than the IRR. They’ll also be much more accurate. Make sense?

Ben Leybovich July 10, 2014 at 11:09 am

Jeff – you see through the bull better than most – I’ve told you that before ::

IRR is fool’s gold. As the syndicator, I can manipulate and engineer IRR to be anything I want it to be to a very large extent. In order to understand this, people need to understand more about how the IRR works (perhaps in an upcoming article

This game is all about cash flows…not the kind of cash flow the newbies talk about, but the kind that you and I know. The sad reality is that sophisticated investors look at IRR as the definitive metric, not realizing that IRR says almost nothing about the health of an investment, which is all about discounting the cash flows properly. SO – are they really as sophisticated as they think, Jeff?

We do not underwrite to IRR – that’s akin to lying to ourselves. People shouldn’t worry so much about the IRR, and focus more on what’s important…

Still love me Jeff?

Jeff Brown July 10, 2014 at 11:12 am

Yup, and as always, you’re still crackin’ me up.

One last observation. The modified return will be just as reliable as the IRR analysis from whence it came. Learned that one the hard way. #bloodynose

Josh Slater July 10, 2014 at 12:38 pm

A question about accounting for the time-value of money. If you do a simple IRR calculation, say for \$1000 spent in Jan-11, and \$1000 received in Jan-12, the IRR is 0. Given that we made no money in a year, while the buying power decreased, I would expect a negative IRR.

So, how is the time value of money reflected?

Ben Leybovich July 11, 2014 at 7:10 pm

Good question – I do not have the answer…

Giovanni July 10, 2014 at 3:26 pm

Great post and comments Ben. I would only add to your segue that leverage doesn’t necessarily improve the CCR. The CCR could go down depending on the terms of the financing too. In that case the deal would be negatively leveraged. In fact I would say that anytime the CCR is lower than the buyer’s cap rate (Based on the entire cost of the deal including purchase price, commissions, closing costs, loan fees, third party reports, legal, immediate capex, etc.) is higher than the CCR a deal is negatively leveraged and that a better deal should be sought.

Ben Leybovich July 11, 2014 at 7:12 pm

Wow – yeah, I guess CCR could go down with terms that are horrendous. But, who is that stupid Giovanni?! Seriously – this never even occurred to me…;lol

Shaun July 11, 2014 at 2:09 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.

Ben Leybovich July 11, 2014 at 7:10 pm
Nick Leamon July 17, 2014 at 9:59 am

Hey Ben,
Love your writing, cracks me up every time, and I usually learn something. When I was in college I learned how to calculate IRR by hand (old school professor) but only basic scenarios. So I was wondering if you would upload that fancy excel IRR spreadsheet you referenced above to BiggerPockets, and if you already have if you could post a link here too it.

Thanks Ben and keep on keeping Brandon honest!

Ben Leybovich July 17, 2014 at 11:59 am

Ha – working on a fancy spreadsheet now; talk to me in about 5 years… The thing about IRR is knowing how to account cash flows; that’s the hard part!

As to Brandon – he has been lost to society for a long time now, and try as I may I can not bring him back

Thanks so much for reading my stuff Nick!

Susan Gillespie July 18, 2014 at 11:21 am

Good topic, Ben. IRR is often misunderstood and underappreciated. Investors evaluate several deal variables, not just a single number, so IRR should be part of the analysis.

The concept of IRR is straightforward, but its calculation is more complex. IRR is the rate of return for all of the investment’s cash inflows and outflows, including purchase and sale, and everything in between.

To calculate, most people are better off using reliable financial tools, not homemade spreadsheets. I can help you with a cloud-based IRR calculator any time you need it.

To Paul Lopez’s point – yes, I include projected capital expenses in the model, as that investment impacts IRR. Again, you want to capture cash inflows and outflows.

Investors need to validate the numbers related to their own deals. By understanding IRR and being able to run their own numbers, investors won’t have to rely on “manipulated or engineered” IRR from sellers. (Not that you do that.)

I do take issue with infinite return. It takes money to make money, even if it’s not your money, and while a return may be high, it is not infinite.