Using Internal Rate of Return to compare Investments
Internal rate of return (IRR) is widely used to compare investments, not just in real estate but in all types of investments. In real estate syndications, projected IRR is an important metric that investors use to compare multiple deals.
Many investors do not understand IRR well but still use it to make investment decisions. A simplistic example that I often hear when someone explains IRR is this one - if you invested $100 in a real estate fund that paid $10 at the end of each year for four years and redeemed at the end of the fifth year for $110, then that investment has an IRR of 10%. This example is correct, but is not helpful in real life when evaluating deals because real deals have a lot of variances in cash flow and in the timing of cash flow.
Why is IRR so hard to understand
There are good reasons why IRR is hard to comprehend. A quick google search will provide the following definition of IRR.
Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero.
What? That treacherous definition is the first reason why even sophisticated investors get queasy in the stomach when asked about IRR. The second reason why IRR is difficult to grasp is because it usually cannot be calculated on the back of a napkin or in your head.
So what should investors do to get their heads around IRR and calculate IRR when needed? The best way to understand IRR is to use Microsoft Excel or Google sheets and learn the use of XIRR function.
How to calculate IRR
Calculating IRR in a spreadsheet is done by creating a time series of cash flows. First column is a listing of all the dates of cash flows including initial investment, distributions, and final payout etc. The second column is the dollar amount for those events. The IRR can then be calculated using the “XIRR” function in the spreadsheet with the appropriate ranges. This is best understood with an example.
Let’s say you invested 100 dollars in a venture on 6/25/2012. For next 4 quarters, you received quarterly profit distribution of 5 dollars each quarter and then finally the venture closed on 09/30/2013 and you received the final payout and return of initial investment as shown in table below. This will lead to an IRR of 21.23% that can be easily calculated using the XIRR function.
Below is the spreadsheet snapshot showing all formulas that have been used:
Note that cash outflows are entered as negative amounts and cash inflows are entered as positive amounts.
Are two investments with same IRR equal?
Syndicators market their investments based on target IRR. A higher IRR generally coincides with higher risk. For example, you can usually increase your IRR by increasing leverage, i.e. borrowing more money. Higher leverage generally means higher risk.
As an investor, if you are presented with two investments that have similar risk profiles, it may seem that you should always choose the investment with higher IRR. But the real answer, unfortunately, is not that straight forward.
Assuming you are comfortable with Microsoft Excel and use of XIRR function, let’s dig into an example that explains why two investments with same IRR can have very different outcomes for an investor.
Investment A and Investment B are made on 9/30/2017 for a thousand dollars each in two different syndication deals. Each investment pays yearly on 09/30. The hold period for both is 10 years – both syndications are dissolved on 9/30/2027. Note that syndicator running investment A refinances at end of year 2 and returns $700 capital to investors. The Syndicator running investment B chooses not to refinance.
The table below shows the cash flows and calculation of IRR for both investments.
Investment A and Investment B both show an IRR of 10%. If you focus on just IRR, you would think the two investments performed the same. However when you calculate the total cash paid out during the 10 years of investment, investment A paid $1550 while investment B paid $2000. In other words, your initial investment of thousand dollars grew by one and half times in syndication A while it grew by 2 times in syndication B. That is your equity multiple (EM). The equity multiple is defined as the total cash distributions received from an investment, divided by the total equity invested.
Here is the spreadsheet showing all formulas that have been used:
Which Investment is better?
Now that the numbers above show that syndication B has better Equity Multiple (EM), should investors ignore IRR and use Equity Multiple (EM) to choose syndication B over A when presented the choice. Not so fast!
To truly understand what is going on in above example, we have to ask this question - why is the IRR same in these two investments even though the actual cash returns are wildly different. The key is the timing when the cash is returned to investor. IRR by definition assigns value to time. In the first example, 70% of the initial investment was returned to investors through a refinance event at end of year 2. The IRR of a real estate syndication (or any deal) increases when the asset is refinanced and the proceeds are disbursed to investors. The IRR calculation assumes that investors receiving the $700 payment at end of year 2 will be able to reinvest that $700 at 10% for the remaining duration of the investment.
This is very important to understand - IRR has an implicit assumption that the investors will be able to deploy any cash flow and returned capital in another investment that will provide returns of similar scale as the current investment. As an investor, you should be aware that if your capital is returned early and you are unable to deploy it and get returns same as your current investment, then your IRR over the investment time frame can be much lower than the IRR mentioned in the investment offering document.
So ultimately the answer to the question, which investment is a better choice, depends on the investor’s individual circumstances. If the investor has avenues to make the cash-flow and returned capital work for them and earn higher returns, then syndication A can be a good choice. But if the investor is unable to deploy the capital returned at year 2 and the money sits in a bank account, syndication B is a better choice for the investor.
I hope this helps shed light on IRR and why it’s important to consider other factors besides IRR to make better investment decisions.
Do you know any other factors related to IRR that are obscure or misunderstood? What else is important when it comes to comparing and choosing between investments. Share your expertise in comments below.