Well – that all depends…
I wrote an article entitled The Definitive Guide to IRR a few weeks ago, in which I discussed the basic premise behind the Internal Rate of Return metric. I mentioned in that article that a lot of sophisticated investors like to use this metric to assess an investment opportunity and to differentiate between several opportunities.
In this post, I’d like to dig a bit deeper into the function that is the IRR. I actually do not believe the IRR to be the definitive metric that many think it is. In fact, IRR could, under given circumstances, be downright misleading…
Instead, the interpretation, the tracing, if you will, of how we arrive at the IRR is really what’s important and what communicates the validity and safety of any given investment opportunity.
The IRR can be manipulated by those who understand how it works in order to represent much healthier investment than what actually is. While doing something may result in a higher IRR, it may also have the side-effect of introducing operational risk which may negate the returns in the long run.
Therefore, as I, or any other syndicator, presents you with an investment opportunity, you must be able to trace all of the steps in the process which culminates with the IRR in order to assess the risk that each represents.
Let’s explore this a bit. My thesis for today is the following:
Knowing by what means we arrive at the IRR is more important than the IRR itself…
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A Review – What is IRR?
IRR is most simply understood as glorified Cash on Cash Return which, however, accounts for all in-flows and out-flows of equity over a specific period of time, not just beginning and the end.
IRR also allocates value to time, which is to say that money spent today is worth more than money spent tomorrow, and money received today definitely has more value than money received tomorrow…
Thus, if you buy a building, hold it for 5 years, and never put any money into it, then your range of inputs looks like this:
Year 1: Minus Initial Equity Investment (Down-payment/Closing Costs, etc)
Year 2: Plus CF
Year 3: Plus CF
Year 4: Plus CF
Year 5: Plus Cash Sales Proceeds after expenses
If you enter this range into Excel, the IRR function will calculate the IRR. Now – do you have to use the IRR to place value on this investment? No, you could simply stay with the annual and annualized CCR over the life of investment.
One thing to keep in mind, however, is that this is an overly simplified example in which there were no additional expenditures past the initial acquisition. Using CCR to reconcile the ROI with a lot of money moving in and out is impossible.
Also, CCR wouldn’t account for time value of money, which is to say that the cash flows in year 5 are less valuable than those in years 1 and 2 due to inflation. Inflation is a real cost, and therefore the IRR, which does indeed account for this, is a more definitive metric.
Simply from looking at the above range and reading the definition, it should be apparent that what drives the IRR metric is the “movement of cash”.
As I mentioned, our example is overly simplified in that it presumes a unidirectional movement…as if! If all we had to do was to buy income property and collect revenues, everyone would be doing it and everyone would be winning – it ain’t that simple. And, the more money moves in and out, the more intricate the range becomes.
Here’s the thing, since the movement of cash as it is represented in the range for IRR is the defining factor, then two realities are present:
- The information inside the range must be accurate in order for IRR to truly have meaning relative to the health of the investment.
- If I can re-allocate and re-time movement of cash, then I can dramatically impact the IRR.
I don’t want to spend time on the second point today, aside for telling you that timing of cash flows can and does dramatically impact the over-all ROI as represented by the IRR, and it takes an experienced operator to know how, why, and when to time these cash flows in order to amplify the partner’s IRR.
The problem lies in the fact that projections can, and often are made which are somewhat less than conservative, and while the resulting IRR looks good on paper, reality down the road might be somewhat underwhelming…
You, dear sophisticated investor who won’t look at an investment opportunity unless it’s measured relative to IRR, are indeed the person on whom it falls to read behind the numbers to know if the IRR means anything. I can put it on the platter in front of you any way you want it, but do you know what the hell you are looking at…?
You see, it all simply comes down to being able to accurately project the cash flows. The moral hazard is certainly there for the over-eager syndicator to inflate the positive cash flows and to underestimate the negative. And it is your job, as the Limited Partner considering investing in a syndicated opportunity, to be able to critically underwrite the opportunity in order to establish whether the assumptions made by the syndicator are reasonable.
Can you do this?
SEC Regulation D Rule 506 stipulates that only Accredited Investors along with a limited number of Sophisticated Investors can take part in Private Placement investments (PPM), which is the proper vehicle for syndication. The point here is that a certain, quite advanced level of sophistication is required to play the game.
While the majority of SEC’s thrust in defining your level of sophistication is relative to your income-potential and wealth, it does very little to address your capacity to discern a good investment from bad! In other words – just cause you got money, don’t make you smart…And I have to tell you, as well, that there is doubt in my mind about whether that guy who advises you about money has any more aptitude to keep you out of trouble should you come across unscrupulous RE syndicator!
I think you should be smart.
Investments in syndicated RE purchases are inherently risky. I am proud of you for knowing about the IRR, because most people don’t even know what that is.
However, being smart in this sport is both a lot less sophisticated than you think, and a million times harder – it’s cash flows, stupid; being able to discern, predict, and allocate cash flows is what makes you sophisticated. Can you?
Obviously, it is absolutely crucial that you deal with reputable syndicators who are going to be conservative in their assumptions, and who are going to lay out for you all of the available information, not just bring you the IRR.
Guys – what makes a syndicator 5-star is that he or she will disclose to you an honest projection, which is based on facts, of what the cash flows will look like.
This, aside for character, is also a function of experience. Estimating cash flows is hard stuff indeed, really-really hard. What makes you sophisticated and a candidate for investing is that you can check the syndicator’s work and not take it for granted…
Well – that doesn’t even scratch the surface, but I’ve spent an hour. Bottom line, if I got you to realize that in spite of all that money sitting in your accounts you are stupid, don’t know anything, and really need to educate yourself, then I’ve put you on the right track and I feel good about it!
Be sure to leave your comments below!