Please explain in more depth IRR

9 Replies

@ Llewelyn A. -

You posted this on another thread:

"Mike, Jay, like both of you, I buy based on Internal Rate of Return (IRR) Analysis, not on calculations that only tell you what the current year return gives you.

I met a few BP members recently and showed them how large the Returns are and it's quite shocking. Those investing in Cash Flow ONLY calculations versus the overall return such as IRR don't realize how much money they are leaving on the table.

I don't blame them because it's just so easy to do those other simple calculations such as CoCR and to think that's the only thing you really need to know.

The problem is that you don't know what you don't know until you learn something sophisticated and then you realize that the stuff you learned before just wasn't good enough to achieve MASSIVE returns.

I think the best kept secret is these more sophisticated calculations such as IRR.

The problem is even if I let the secret out of the bag, there will probably be 90% of Investors that will say it's too difficult to understand. And I agree! It really is difficult because it requires a mental and business shift of paradigm.

But like everything, if you put in quality work, you can get quality rewards."


Can you go into more depth about IRR?

I found this article to be helpful in understanding IRR: https://www.crowdstreet.com/what-internal-rate-ret...

Am I on the right track?  I guess I'm not seeing what is so magical about this formula yet...or why it "requires a business shift of paradigm"?

Thanks

@Tandi H.

Hi Tandi,

To go into complete depth with IRR, it will take an entire book!

In fact, there is an entire book! It's called "What Every Real Estate Investor needs to know about Cash Flow..." by Frank Gallinelli

Either case, I put together a very quick spreadsheet (took me 10 minutes) as an example. Please refer to this Spreadsheet:

To do a basic IRR calculation, you will need to project out a bunch of things including:

1) Your Investment: Cells A1 to B7

2) The Mortgage Balance Reduction: Cells A9 to B14

3) The Future Value you will sell the Investment: Cells D1 to E12

4) The Proceeds after the Sale: Cells D14 to E21

5) Your Rents and Expenses and how they will increase throughout the 10 Years: Cells H1 to L2

6) A Chart which will take into account all the above for the next 10 years: Cells G6 to M18.

After totalling up everything, you will get a single number. In the above case, 9% IRR.

You should think of it as putting the Investment in to a Certificate of Deposit, holding it for 10 years at the 9% IRR per year for the 10 years.

The IRR Calculations gives you a fantastic way to calculate ANY type of Investment against each other, including Stocks, Bonds, Real Estate, ANYTHING really.

Once you know all the Cashflows for the entire 10 year target life of the Investment, then you can get an IRR for it.

Now, let's look at a 2nd Scenario with this EXACT spreadsheet, but with different numbers:

We increased the price to $500k, buying in a location that has at least the national appreciation rate. The rent for the property is $3k per month with around a $650 per month total expense, but our mortgage is $2,398 per month, giving us the 1st year at a NEGATIVE cash flow of -578 annually or around a negative $50 per month loss.

If you notice, the IRR calculates 14%... which is much higher than 9% in the first scenario.

Typically, I accept a break even scenario to capture a much higher IRR. I have purchased 8 Multi-Family Brooklyn Properties in 21 years. At least 2 started out negative. All are doing significantly better then even a 14% IRR.

To give you a little bit of what I'm saying in terms of SIMPLE INTEREST CALCULATIONS, in 2004 I bought a property for $880k with approximately 25% down or roughly $250k invested. TODAY, that property is worth over $3 Million. If I sold it today, I will get back around $2.5 Million in Proceeds. If you do the SIMPLE INTEREST Calculation, you get a profit of $2.25 Million for an investment of $225k. The ROI is 900%. If you divided it by 14 years, that's roughly 64% per year for 14 straight years. NOTE, this does not even consider Cash Flow. TODAY, we Cash flow over $3,500 per month but when we started, we barely broke even.

So, without going too much into things, you can see how a basic IRR pro-forma 10 year business plan is put together.

This isn't even close to what the professionals would actually do.

We need to justify every number. For instance, why did we chose a 5% Appreciation rate? Well, it could be that the historic appreciation rate for the city and neighborhood is close to 10% (Brooklyn NYC is actually even higher than 10% for the last 20 years in the neighborhoods I have invested in). So 5% is CONSERVATIVE depending on where you are investing.

We can then look at how the rents and expenses are moving up. A 2.5% increase of market rents in NYC

is WAY TOO CONSERVATIVE while a 3.5% increase in Expenses is somewhat normal.

ANYWAY... I don't want to write a book for this post. I think you get the picture on how comprehensive and sophisticated you have to be in order to put together something like this.

Remember, this is a very simple and basic pro-forma 10 year projection IRR Business Plan. All numbers must be explained and justified.

I won't explain every calculation on this spreadsheet, but I think the reader of this post will get an understanding.

This is what I recommend on EVERY investment. That would also include EVERY TYPE of investment, not just Real Estate.

Hope some of this helps with the explanation of IRR.

Once you get a full understanding of it, you can then look at all the kinds of Real Estate in any kind of City and then put in the pro-forma assumptions conservatively.

When you do enough of these, you will start to get a picture on where is the best place to invest (or even what type of investment is the best) simply by looking at the IRR that is calculated.

Other factors that are not put into this spreadsheet are Cap Ex, Vacancies, Legal, etc.

But given all of those variables, you can add them into your IRR Calculations and project them out over the 10 years.

OK... I'm not going to beat a dead horse. You get the point.

@Tandi H. , Ben said "It's a start". The next step could be to account for where we all are in the "cycle" at any given time. Interest rates? Purchase price? Banks' willingness to lend? Rent increases/decreases? And these things don't include other value-add opportunities, which can be different for every property! And don't forget: all Real Estate is local ie. what use statistics?

Now what do you reckon about Internal Rate of Return? Cheers...

Originally posted by @Brent Coombs :

@Tandi H. , Ben said "It's a start". The next step could be to account for where we all are in the "cycle" at any given time. Interest rates? Purchase price? Banks' willingness to lend? Rent increases/decreases? And these things don't include other value-add opportunities, which can be different for every property! And don't forget: all Real Estate is local ie. what use are statistics?

Now what do you reckon about Internal Rate of Return? Cheers...

 @Ben Leybovich hearts IRR .. ;)

@Llewelyn A.

@Ben Leybovich

@Brent Coombs

Wow Llewelyn, thanks!  I will get the book you recommended, and start my research.  

Thanks for all the inputs.  I have an inkling now of how the "what's the cash flow" perspective may not be effective in evaluating properties.  Excited to delve into this area.

Originally posted by @Tandi H. :

@Llewelyn A.

@Ben Leybovich

@Brent Coombs

Wow Llewelyn, thanks!  I will get the book you recommended, and start my research.  

Thanks for all the inputs.  I have an inkling now of how the "what's the cash flow" perspective may not be effective in evaluating properties.  Excited to delve into this area.

 "What's the CF" perspective is very effective. Just not in the way most people view it. Keep studying!

@David Roberts

Hi David,

I added a column for the New Financing situation as you asked:

I zeroed out the Financing from the Purchase by making the DP% = 100% so you did not carry a mortgage.

I also lowered the CC% to 3% because you no longer had to carry a Mortgage which generally, you will need to have to pay a Mortgage Tax.

In the I Column, I added a new Finance Column where in 2020 you received $400k in your pocket.

HOWEVER, in 2029, you must then pay it back. If you used a HELOC to get the $400k, you will be paying Interest on that $400k. If you used an Interest Only HELOC at 6% you will be paying $24k per year on Interest for the outstanding balance. NOTE that you are gambling that the Interest Rate will AVERAGE 6% for the HELOC. If it increases above that, you will negatively impact your Cash Flow which will then impact your overall IRR.

You will see that it does not significantly impact the previous spreadsheet IRR if we assumed a 6% Average HELOC Interest Rate. So both IRR are 14% as it is in these scenarios.

The only reason to do this is to negotiate a better Purchase Price, but again, you are taking a chance that the HELOC is 6% on Average. You CAN do a cash out refinance and lock in the rate, but the rate will be significantly worse than on the Purchase. So again, you will need to take that into consideration.

You will need to throw into the mix whether or not getting a better price on Purchase for an All Cash deal is worth it, depending on the finance in the 2nd year.

BUT, if the price at purchase was the same, then you will not receive any more profit than what you would have had if you bought it with a Mortgage in the beginning.

See how useful these Calculations can be?

Without this kind of calculation, I really don't know how others are handling complex scenarios. To me, if you only use a calculation like Cash on Cash Return (CoCR), you can only know the 1st year and then what?! You make the assumption that it will do the same for the next 10 years?!

Ummm... I have a real problem with that! But it's up to the reader to decide if they want to get a better vision of the future of their investment.