AAR vs IRR - What is your definition?

3 Replies

Hi everyone,

When talking with other investors there seems to be a lot of confusion between the definitions of AAR vs IRR. Can everyone please share their best definitions of the two and which metric you share with your investors?

Thanks!

Kyle

There shouldn't be any difference in the way one investor defines these terms, compared to another investor. They are standard terms and should be calculated the same way. It would make it impossible to compare investments if everyone had their own definition. It would be like each broker defining 'cap rate' differently, or 'actuals' (there's a joke in there somewhere).

As for the differences between the two, AAR takes depreciation and taxes into account. I have not personally seen it used in a sponsor's marketing. The common metrics are cash on cash, IRR, and ROI.

I share both. But personally I prefer IRR because, as I'm sure you know, IRR takes into account the time value of money. And if someone doesn't quite understand that, here is my explanation for that.

Let's say that you invest $1000 in my property. 

Scenario 1 - If at the end of each year I give you $100 then that's a 10% COC return.

Scenario 2 - If I don't give you any money at all for 5 years and then at the end gave you $500, that's still a 10% return. 

Scenario 3 - If at the time you initially invested I had immediately turned around and handed you back $500 and not given you anything for the next 5 years, at that 5 year mark it still would be a 10% return.

Obviously there is a difference in those 3 above scenarios, despite the fact that the COC is the same, and that difference is when you get the money.

@Michael Le gave a great run down on different scenarios that all have the same total return over a similar hold period but with different IRRs.

On the flip side though, you can have a deal that has a higher IRR but a much lower total return over the same hold period.

IMO IRR should be used more as a hurdle than an end all be all metric.

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