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