Mastering IRR as a Passive Investor in Syndications
Real life investments have expected cash flows that are complicated and difficult to compare (Figure 1). IRR provides a convenient way to determine which investments are prefer able from the standpoint of the growth of your capital. As an added bonus, once you understand IRR, you will be able to confidently invest in a syndication as a passive investor. You will need to master IRR to understand the cash flow and capital event waterfalls that determine how investors get paid in these deals.
Figure 1. IRR isn’t rocket science! This article will teach you how to (easily) calculate IRR using a spreadsheet program. You can get miles ahead of other investors by learning to do the things that others refuse to do!
A Gentle Introduction Using (Very) Simple Math
Suppose you were offered two investment opportunities. Both require the same principal investment of $100,000. The first has a return on investment (ROI) of 25% and the second has an ROI of 100%. What should you do to determine which investment is better? You should ask “how long is my money tied up?” Suppose that the fist investment returns $125,000 one year from the date of investment and the second returns $200,000 but requires five years to return your money. In the case of the first investment, your rate of return is obviously 25%. But what about the second investment? The second investment yields only 14.9% per annum! You would be much better off taking the “quick nickel over the slow dime” and getting $25,000 for a one year holding period and then reinvesting that money over the next four years. Of course, the preference for the first investment is based on the assumption that you can find an investment that will produce $75,000 on your principal of $125,000 over four years, which represents an annualized rate of return of 12.4% compounded yearly (Figure 2).
Figure 2. A quick nickel beats a slow dime. A 25% gain in one year beats a 100% gain in 5 years by a wider margin than you might imagine. If you take the investment on the left, you would only need to make 12.4% on your money annually over the next four years to do as well as you would with the investment on the right.
Additionally, there are many things we will not be able to cover in this article including the impact of inflation, the effects of taxation on your wealth (and the advantages of deferring taxation) and the fact that the most important part of any investment analysis is quantifying the risk to your capital and the likelihood of the upside materializing.
Internal Rate of Return (IRR) IRR calculates the total return of an investment by finding the discount rate that sets the present value of all cash flows equal to zero. Another way to think of this is that it finds the rate of return capable of producing the stated cash flows. Before computers, this was a laborious, “guess and check” affair. Nowadays with spreadsheet programs, it is a cinch.
IRR is particularly useful for judging the total lifetime return of an investment. Some of the less sophisticated gurus will tell you that “once you return 100% of the cash invested, you have an infinite rate of return”. If only it were that simple. One might ask such gurus, if you are receiving an infinite rate of return, why aren’t you infinitely wealthy? Once you master IRR, you will know better, and what’s more, you will be able to properly calculate your return on these investments. An investment that can continue to provide a reasonable cash flow after returning your principal may be a great investment, but as we will see, it is certainly not infinitely so!
Now you know better, you can use the IRR to calculate the rate of return in these situations. IRR is far from perfect, it does not take into account inflation and only you can determine whether a particular investment is desirable given the expected return and the risks involved. Study the formula below to develop an intuitive understanding of IRR. If the formula doesn’t make intuitive sense to you, take heart, in practice, you will generally be using a spreadsheet to calculate IRR.
IRR – A Real Life Example from Syndication
Now that we have gone through the formula and a simple example, we can examine a more complex example that illustrates the true value of IRR. In our prior examples, we had a single cash flow that is analogous to a zero-coupon bond. We could have arrived at the same conclusion using much simpler methods such as compound annual growth rate (CAGR). When we have multiple cash flows that vary over the course of the investment, you will find a more robust method such as IRR to be very handy. The following example will serve to illustrate.
Consider the following apartment repositioning. The acquisition requires $500,000 capital which includes the following: $250,000 down payment, $210,000 construction costs, $10,000 closing costs, and $30,000 working capital. Let us track a $100,000 investment in this deal which represents 20% of the total capital invested. We will use a 70% / 30% (GP/LP) split for all cash flows. We will assume a 75% loan to value (LTV). Furthermore, we will assume that the apartment will be repositioned in 5 quarters and that the lender will expect six months seasoning before they will close the loan. That is to say, they will expect to see the property operating for six months following the repositioning before reassessing the value. The loan will take some time to close so we will credit the cash flow to the following quarter. Finally, we will assume that the asset increases 15% in value between the refinance and the ultimate sale. We will deduct 6% from the sales price for broker’s commissions (Table 1A).
Table 1A. A summary of cash flows from acquisition and capital events (refinance and disposition).
To use Microsoft Excel ® to solve for IRR, start by listing the cash flows. If your cash flows are strictly annual, you can take the shortcut of using the IRR formula. If your cash flows are anything other than annual, you will need to use the XIRR formula which allows you to specify the timing of the cash flows. In our case, the cash flows will be on a quarterly basis. We will need a column to list the times that the cash flows occur as well. The formula used in the example below is “= XIRR(B2:B22,C2:C22)” (Table 1B).
Table 1B. IRR can be rapidly and conveniently calculated using Microsoft Excel®.
Note that the timing of the cash flows is a key determinant in the magnitude of the final IRR. If the refinance cash flow is received one year later, the IRR sinks from 22.9% to 19.1%. If the refinance can be completed two quarters earlier (the quarter after the repositioning) because you use a local lender that does not require seasoning, the IRR increases from 22.9% to 25.8%!
If instead the property were sold after 2 ½ years, the IRR would only be 16%. In a more complex syndication deal, the general partners may earn a promote (a premium percentage split) by exceeding IRR hurdles to the passive investor (as opposed to a straight split as in this example). In such a case, holding the property for some time after returning most of the principal can vastly increase the returns for the passive investors. This is great not just for the passive investors but for the general partners as well!
To make the determination whether you need to refinance and continue to hold or sell depends on many factors. The best way to approach this question is to continuously re-underwrite your deal under various scenarios during the holding period, not just under two scenarios as in this article. You will want to model these scenarios out after asking several questions such as: What sort of rent and or price appreciation do you expect during the holding period after refinance? What is the likelihood that the market will turn against you in the next x years? What rate of return was promised to investors? When do I begin to earn the promote? Your reward will be maximizing the likelihood of obtaining the highest return. The prize is worth the effort! (Table 2).
Table 2A. A summary of cash flows due to acquisition followed by sale of the property at year 2.
Table 2B. The IRR corresponding to a sale in year 2.
One of the best ways to get ahead quickly is to master tasks that other investors find difficult or “boring”. IRR is only boring so long as you don’t understand it! At this point you should have a powerful new tool in your toolbelt!
This article examines two simple examples, a comparison of two investments with a single cash flow at the end and a simple syndication involving a 70% / 30% split. In practice, syndication waterfalls may be much more complex, although many syndications are as simple as the one described in this article.
The information provided in this article is believed to be accurate but not guaranteed to be so. The author is neither a lawyer nor a CPA. The legal and tax landscape is an ever-moving target. You are encouraged to consult legal and tax professionals in all of your real estate dealings. The author is not responsible for any damages that may result from following or not following the advice in this article.