Is The IRR Metric Any Good When Investing in Real Estate?

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Well – that all depends…

I wrote an article entitled The Definitive Guide to IRR a few weeks ago, in which I discussed the basic premise behind the Internal Rate of Return metric.  I mentioned in that article that a lot of sophisticated investors like to use this metric to assess an investment opportunity and to differentiate between several opportunities.

Related: The Definitive Guide to IRR (Internal Rate of Return)

In this post, I’d like to dig a bit deeper into the function that is the IRR.  I actually do not believe the IRR to be the definitive metric that many think it is.  In fact, IRR could, under given circumstances, be downright misleading…

Instead, the interpretation, the tracing, if you will, of how we arrive at the IRR is really what’s important and what communicates the validity and safety of any given investment opportunity.

The IRR can be manipulated by those who understand how it works in order to represent much healthier investment than what actually is.  While doing something may result in a higher IRR, it may also have the side-effect of introducing operational risk which may negate the returns in the long run.

Therefore, as I, or any other syndicator, presents you with an investment opportunity, you must be able to trace all of the steps in the process which culminates with the IRR in order to assess the risk that each represents.

Let’s explore this a bit.  My thesis for today is the following:

Knowing by what means we arrive at the IRR is more important than the IRR itself…

A Review – What is IRR?

IRR is most simply understood as glorified Cash on Cash Return which, however, accounts for all in-flows and out-flows of equity over a specific period of time, not just beginning and the end.

IRR also allocates value to time, which is to say that money spent today is worth more than money spent tomorrow, and money received today definitely has more value than money received tomorrow…

Thus, if you buy a building, hold it for 5 years, and never put any money into it, then your range of inputs looks like this:

Year 1:  Minus Initial Equity Investment (Down-payment/Closing Costs, etc)

Year 2:  Plus CF

Year 3:  Plus CF

Year 4:  Plus CF

Year 5:  Plus Cash Sales Proceeds after expenses

If you enter this range into Excel, the IRR function will calculate the IRR.  Now – do you have to use the IRR to place value on this investment?  No, you could simply stay with the annual and annualized CCR over the life of investment.

One thing to keep in mind, however, is that this is an overly simplified example in which there were no additional expenditures past the initial acquisition.  Using CCR to reconcile the ROI with a lot of money moving in and out is impossible.

Also, CCR wouldn’t account for time value of money, which is to say that the cash flows in year 5 are less valuable than those in years 1 and 2 due to inflation.  Inflation is a real cost, and therefore the IRR, which does indeed account for this, is a more definitive metric.

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

However…

Simply from looking at the above range and reading the definition, it should be apparent that what drives the IRR metric is the “movement of cash”.

As I mentioned, our example is overly simplified in that it presumes a unidirectional movement…as if!  If all we had to do was to buy income property and collect revenues, everyone would be doing it and everyone would be winning – it ain’t that simple.  And, the more money moves in and out, the more intricate the range becomes.

Here’s the thing, since the movement of cash as it is represented in the range for IRR is the defining factor, then two realities are present:

  1. The information inside the range must be accurate in order for IRR to truly have meaning relative to the health of the investment.
  2. If I can re-allocate and re-time movement of cash, then I can dramatically impact the IRR.

I don’t want to spend time on the second point today, aside for telling you that timing of cash flows can and does dramatically impact the over-all ROI as represented by the IRR, and it takes an experienced operator to know how, why, and when to time these cash flows in order to amplify the partner’s IRR.

The problem lies in the fact that projections can, and often are made which are somewhat less than conservative, and while the resulting IRR looks good on paper, reality down the road might be somewhat underwhelming…

You, dear sophisticated investor who won’t look at an investment opportunity unless it’s measured relative to IRR, are indeed the person on whom it falls to read behind the numbers to know if the IRR means anything.  I can put it on the platter in front of you any way you want it, but do you know what the hell you are looking at…?

You see, it all simply comes down to being able to accurately project the cash flows.  The moral hazard is certainly there for the over-eager syndicator to inflate the positive cash flows and to underestimate the negative.  And it is your job, as the Limited Partner considering investing in a syndicated opportunity, to be able to critically underwrite the opportunity in order to establish whether the assumptions made by the syndicator are reasonable.

Can you do this?

SEC Regulation D Rule 506 stipulates that only Accredited Investors along with a limited number of Sophisticated Investors can take part in Private Placement investments (PPM), which is the proper vehicle for syndication.  The point here is that a certain, quite advanced level of sophistication is required to play the game.

While the majority of SEC’s thrust in defining your level of sophistication is relative to your income-potential and wealth, it does very little to address your capacity to discern a good investment from bad!  In other words – just cause you got money, don’t make you smart…And I have to tell you, as well, that there is doubt in my mind about whether that guy who advises you about money has any more aptitude to keep you out of trouble should you come across unscrupulous RE syndicator!

Conclusion

I think you should be smart.

Investments in syndicated RE purchases are inherently risky.  I am proud of you for knowing about the IRR, because most people don’t even know what that is.

However, being smart in this sport is both a lot less sophisticated than you think, and a million times harder – it’s cash flows, stupid; being able to discern, predict, and allocate cash flows is what makes you sophisticated.  Can you?

Obviously, it is absolutely crucial that you deal with reputable syndicators who are going to be conservative in their assumptions, and who are going to lay out for you all of the available information, not just bring you the IRR.

Guys – what makes a syndicator 5-star is that he or she will disclose to you an honest projection, which is based on facts, of what the cash flows will look like.

This, aside for character, is also a function of experience.  Estimating cash flows is hard stuff indeed, really-really hard.  What makes you sophisticated and a candidate for investing is that you can check the syndicator’s work and not take it for granted…

Well – that doesn’t even scratch the surface, but I’ve spent an hour.  Bottom line, if I got you to realize that in spite of all that money sitting in your accounts you are stupid, don’t know anything, and really need to educate yourself, then I’ve put you on the right track and I feel good about it!

The End

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About Author

Ben Leybovich has been investing in multifamily residential real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben is a licensed Realtor with YOCUM Realty in Lima, Ohio. He is also the author of Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

28 Comments

  1. Jason Brenizer on

    Hi Ben,
    Great blog post! Besides the clearly expressed content, you entertain us with your writing style. Thank you for taking the time to educate the community.
    – Jason

  2. Nick Santaferrara on

    Hey Ben,

    New to BP and loving it! Just wanted to thank you for another great post.

    Keep it coming for us in need!

    Thanks again,
    Nick

  3. Michael Dorovich on

    Thanks Ben for a great article. When you say ‘movement of cash’, would this be determined by verifying the income and expenses for the property?

    Thank you!

    • Ben Leybovich

      That’s a big part of it, Michael. But there are a lot of other events that can be timed as part of a strategy which would impact the IRR, but can also increase risk.

      Thanks so much for reading!

  4. Ok Ben, you got me to realize I am stupid and I really need to educate myself. Now, how do I learn financial literacy? How do I look at numbers so I recognize a better deal? I’ve read some books on the subject but my stupidity won’t allow me to see it and use the info. I’ll read the links you’ve posted, but simple is good for the stupid. Please point me in a less stupid direction.

    • Ben Leybovich

      Steve – when you say “learn financial literacy”, what do you mean? Financial literacy at what level? Are we taking balancing a check book, buying a duplex, a 4-plex, or 150-unit?

      You should be able to find a lot of information right here on BP. Also, feel free to visit my website – I think the CFFU on my site will answer a lot of your questions.

      Aside for that, feel free to reach out!

  5. Great article, just curious in your experience raising money, which metric do investors care the most about. Generally I’m sure that sophisticated investors would understand IRR (both the pros and cons), and that by timing more cash flows earlier they could recognize a higher IRR, but that they would increase the risk of the project. Thanks!

    • Ben Leybovich

      Good question Ben, and the answer is – it depends. Some indicators raise money from high net-worth individuals who focus on Cash on Cash return – these people generally lack sophistication to know IRR. However, a lot of Accredited and Sophisticated Investors do focus on IRR. These are the people I tend to deal with…

  6. Yeah the problem with IRR is that it is heavily weighted for time. So, even though a project may have a higher IRR, the overall value may be less than that compared to another project. NPV should help you, but then the problem becomes finding an accurate discount rate, which is complicated. Modified IRR will also help with the problem of IRR assuming you re-invest the cash flows at the IRR %, but again that pesky discount rate is hard to nail.

      • Jeff Brown

        Josh just nailed it, Ben. IRR is a bold faced lie. The more the cash flows, the bigger the lie. The longer the holding period with large annual cash flows, the bigger the lie still becomes. In today’s economic reality, a double digit IRR done for the analysis of a potential syndication property, assumes something so wildly inaccurate as to make the concluding IRR laughable.

        An example would be a high cash flow property held for a decade, with not much increase in value. That describes many markets in the country, right? If the IRR is 13.5%, and every single assumption for vacancies/expenses etc. was accurate to the penny, this underlying false assumption remains. That is, that the 13.5% IRR to cash flows each year and earned the same 13.5% from the day it ceased being ‘internal’. Not freakin’ likely. CDs are offering rates mostly under 1%. When the cash flows are impressively large, and the holding period is 10 years, imagine how much the two factors of time and internal/external returns skew what the return actually is.

        • Ben Leybovich

          Do I know how to pull your strings, or do I know…lol

          Agree and disagree, Jeff. I will not take action on lower than a solid 16% IRR to investor – perhaps that’s why I have not bought anything in 12 months :)

          High IRR is possible in a value ad proposition with appropriately timed financing. These opportunities are very, very rare in today’s market. However, to say that the only way to show high IRR is to lie, is not correct. 99% of the time that’s how they do it, so you are correct relative to 99% of the opportunities being offered. But, there are good guys out there who underwrite conservatively and buy only when there’s value to be had – helloooo…:)

        • Jeff Brown

          :) It’s not the analyst that lies, Ben. In fact, you and I go out of our way to ensure accuracy, including future assumptions. It’s the model itself that has the lie built in to it. At 16% the IRR flatly asserts that the owner of that property is also getting 16% on cash flows, after they’re not internal any more. That is a lie, period, over ‘n out, no debate.

          IRR is flawed from the get-go, which is why the MIRR is virtually always a measurably lower number.

        • I think IRR is useful, but people put so much weight onto it. It’s useful insofar as it’s a great rule of thumb, like the 2% rule, or 50% rule. It’s a good metric to eliminate things, but it almost always requires further analysis. For example, for a project with something like an 18% IRR, I would look to see the timing of the cash flows, and use NPV and MIRR to look further into the project. For something with an 8 to 10% IRR, I might eliminate that from the get go, or change the offer price.

          So yes, it’s useful, but other steps should be taken in your analysis, IMHO.

        • Ben Leybovich

          Jeff – most of the IRR is not driven by monthly cash flows. In fact, if the cash flows are so high as to be able to drive above about 8 or 9% IRR, then you are in D Class. But, that doesn’t work in reality because in this C and D cash flow looks good on paper. but does not translate – it’s called CapEx…

          Therefore, the IRR to a large extent is engineered via value ad, which, by definition, presumes that the seller has not done it, and capacity to take cash off the table. Value ad is always hard to find, and especially so now. And financing equity off the table, while possible in many cases, is not advisable in most because of the additional risk being introduced via leverage. Unless, big time value ad is there, and the property/market supports it – needle in a haystack…

          So – I look at a lot of deals, but have not been able to take action on any lately…

        • Ben Leybovich

          Joshua – I respectfully disagree with you. The IRR is indeed the most comprehensive and story-telling metric that there is, and not just a rule of thumb. The process of arriving at the IRR incorporates “ALL” of the moving variables in a transaction. Therefore, “TRACING” the process which leads to an IRR is extremely illuminating…

          The problem is that most people only look at the resulting %, and don’t have the sophistication to truly analyze the process which lead to it. Whenever this is the case, the IRR is useless, because it can be engineered t be anything we want it to be. But, tracing the process will tell the whole story – more so than any other metric!

          Thanks so much for reading and commenting!

      • I had a lease option project I modeled out for a single family home. Our plan was to buy hard money, repair, and refinance. Our IRR looked incredible at around 35% or so. By that measure it was a good deal. But after looking further the overall value created by a 3 year lease option was not actually as much as it seemed. Compared to offering the property on a note for 20 years, even though the IRR was much less, the overall wealth creation was more, at a specified discount rate. Had our discount rate been somewhere around 22% or something very high, then the lease option provided a better option. (Assuming they actually exercise the option and never refinanced. 2 unlikely scenarios but perfect for making my point.)

        All I’m saying when I say rule of thumb is that IRR should not be the only metric used.

        • Jeff Brown

          What I don’t get, Josh, is why MIRR isn’t the Captain Obvious ‘go-to’, since it gives a far more reliably accurate picture. I’ve always done it on every analysis since 1980, no exceptions. It still allows me to know with confidence that I’m comparing apples to apples.

        • My thought, and correct me if I’m wrong as you have been analyzing deals for longer than I have been alive, is that the MIRR can be subjective tho who, or what entity, is analyzing. It’s mainly because of the finance rate and re-investment rate can be different from entity to entity or person to person. Moreover, those rates take time and some data to figure out I feel like. Maybe I’m wrong but MIRR and NPV are not as ‘universal’ as IRR.

          But really, in the end it’s all wrong anyways! The numbers are always off, no matter how long you take to perfect a model it’s never right.

        • Jeff Brown

          Hey Josh — The only difference MIRR provides for me is the ability to impute the rate of after tax return for annual cash flows which are no longer internal, as IRR implies they are. I don’t need as much crystal ball projecting to know that if I did one today, my after tax ‘safe’ rate for cash flows would be less than 1%. During a 5-10 year hold, could that rate be off in the latter years by a ton? You bet. But are they gonna be higher, or lower? :)

          Back in the early 80s — Yeah, I know. You hadn’t been born yet :) — That after tax ‘safe’ rate was was up to 14% minus income taxes. But, since the Fed was then beginning to show results with their tightening, inflation and Fed rates, and therefore CD rates began to decline. We still had the impossible task of forecasting the safe rates several years down the road.

          The key value to MIRR for me, Josh, is that it more credibly allows the analyst to compare apples to apples due to its treatment of cash flows once they’ve become ‘external’. Make sense?

    • Ben Leybovich

      Haha – I still got surprises for you Jeff :)

      I am always looking for Cash Flow. But, that’s only one indicator of health, and there are many. And – they all have to work in synthesis. Underwriting is knowing how to manage this synthesis…

      Metrics in and of themselves mean very little. But, metrics tell a story of the process, and that holds the keys to the kingdom. People don’t get it, but tracing the means by which the metrics are arrived at is the key to understanding any given opportunity. This, unfortunately for most, takes an incredible level of sophistication which people don’t have…

  7. I think the big point you are making that seems to be missed some what in the debate over how good the IRR is, is the fact someone can mess around with it to say what they want if you don’t look at the under lying data.

    Let’s say a syndicator is putting together a deal with a 10 year exit. In year 5 they plan on refinancing the property to do some capital improvements and some early capital profit tax free for the group. They expect the cash flows to go down 20% at that point until they sell. Well running the IRR they don’t hit the minimum the investors say they want. To save the deal they say that instead they will refi at the end of year 3 and now the IRR looks much better.
    (Going to try to paste some excel cells, no idea if it will work)
    refi 3 refi 5 refi 7
    initial -10000 -10000 -10000
    y1 1000 1000 1000
    y2 1000 1000 1000
    y3 11000 1000 1000
    y4 800 1000 1000
    y5 800 11000 1000
    y6 800 800 1000
    y7 800 800 11000
    y8 800 800 800
    y9 800 800 800
    y10 10000 10000 10000

    IRR 23% 19% 17%

    If this shows up the first shows the “cooked” IRR of 23% (Lets say the investor asked for 20% minimum) then the next is the intended strategy. The last one is if they did it after year 7 (I say at the end so the extra 1000 is the cash flow for the year then the 10,000 is the money taken out). This is if say there was a short down tick the first few years in the economy and the value wasn’t where you needed it to be to get the right refi (Of course then the cash flows would likely be less as well… details blah…).
    So the real expected IRR was 19%, the guy tweaks the numbers a little to get it to look like 23% to make people feel good about it, but then in reality something actually happens to make the initial projections off and it is 17%.

    Main takeaway for people should be:
    1) It is easy to manipulate the numbers to make them look like what you want.
    2) Even your best and honest attempt to project things several years in the future will LIKELY be wrong.

    • Ben Leybovich

      Shaun – In my writing, I enjoy leaving room for individual interpretations. For this article, I chose to, as they say, lead the horse to water, but stop short of making it drink – you picked up where I left off…:)

      People will hear and see only what they choose. The wise reader will deduct meaning similar to that which you articulated so precisely – the rest will argue minutia. That’s OK; they are not ready…

      Thank you Shaun!

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