The Definitive Guide to IRR (Internal Rate of Return)
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.
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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%
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.
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.
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.
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.
That’s hard to find indeed!
What metric of real estate investing do you find most difficult to understand?
Be sure to leave your comments below!