What Is A Good Internal Rate Of Return For Real Estate?
New Passive Investors Circle members have a burning question: “How do you figure out if a real estate syndication is a good investment?
One of the more popular tools to help with this is the Internal Rate of Return or IRR for short.
It’s important in the real estate world as it shows how much cash we can make for every dollar we put in and for how long.
Deciding what makes a good Internal Rate of Return can be challenging due to the various investment options available. What makes a good IRR can change based on the specific industry, details of the individual project, and the level of risk an investor is willing to take.
Suppose you’re considering buying a property (active investing) or taking a more leisurely approach (hands-off) with real estate syndications. In that case, it’s important to know about the Internal Rate of Return to ensure a successful investment experience.Join the Passive Investors Circle
What Is Internal Rate Of Return (IRR)?
As an investor, I always aim to evaluate the potential profitability of my investments. One key financial metric that helps me with this is the Internal Rate of Return (IRR). The Internal Rate of Return tells me how much an investment is likely to grow each year.
It takes into account that money might be worth less in the future than it is now. So, it adjusts the future earnings from an investment to what they would be worth in today’s dollars, also known as the ‘discount rate‘.
Understanding IRR is important for comparing and selecting investments. An investment with a higher IRR is generally more desirable than one with a lower IRR. However, it’s important to consider any potential risks and other financial metrics before making a decision.
How Do You Calculate The Internal Rate Of Return (IRR)?
To calculate IRR, you can use a formula that finds the discount rate that makes the net present value (NPV) of an investment’s cash flows equal to zero.
The IRR formula involves cycling through different discount rates until the NPV equals zero. Here’s the general formula for NPV:
NPV = (Cash Flow at Time 1 / (1 + IRR)^1) + (Cash Flow at Time 2 / (1 + IRR)^2) + ... + (Cash Flow at the end / (1 + IRR)^n) - Initial investment
- Cash Flow represents the inflow and outflow of money over the period
- IRR is the Internal Rate of Return as a decimal
- n is the number of periods until the end of the investment
The bottom line is that calculating IRR by hand is very hard to do, and few people do it. Instead, most calculate IRR in Excel or use an online financial calculator.
By understanding the basics of IRR, I can better assess my investments’ potential annual growth rate and make more informed decisions. Remember, while IRR is a valuable metric, it’s still crucial to consider other financial factors and metrics before diving into any investment opportunity.
What Is a Good IRR?
Comparing IRRs and Hurdle Rates
When evaluating a good internal rate of return (IRR), consider comparing the IRR of different investment opportunities to identify which one has a higher potential for profitability. A higher IRR typically indicates a better investment opportunity, while a lower IRR could signal a less attractive investment. However, it’s important to consider the investment’s risk profile, as a higher IRR may come with increased risks.
Another factor is comparing it to the hurdle rate or the minimum required rate of return. The hurdle rate acts as a benchmark for deciding if an investment is profitable enough to pursue.
If the IRR exceeds the hurdle rate, it’s generally considered a good investment, as it indicates that the investment has the potential to beat the required minimum return.
Investment Time Frame Impact on IRR
The investment time frame plays a significant role in determining a good IRR. A shorter time frame may yield a higher IRR, making an investment appear more attractive. However, this can sometimes be misleading, as an investment with a longer time frame may generate higher total returns even if its IRR is lower.
Therefore, I carefully consider the investment horizon while evaluating IRR to ensure that I’m comparing investments with similar time frames fairly.
Modified Internal Rate of Return
The Modified Internal Rate of Return (MIRR) addresses some limitations associated with the traditional IRR, such as the assumption that cash inflows are reinvested at the project’s IRR. MIRR provides a more realistic measure of an investment’s profitability by considering the:
- reinvestment rate
- financing costs
- time value of money
By evaluating both the IRR and MIRR, you can make better-informed investment decisions by comparing various investment opportunities, taking into account their associated risks, and considering the time frame of the investments.Join the Passive Investors Circle
IRR in Different Investment Types
Real Estate Investments
In my experience with real estate investments, a good internal rate of return (IRR) can vary depending on:
- type of property
- investment strategy
For example, rental properties can offer a relatively steady stream of rental income, while commercial real estate investments may entail more significant cash flow fluctuations.
When evaluating a potential investment property, factors such as property appreciation, rental income, and the costs associated with property management must be considered. It’s generally believed that an IRR above 15% is considered attractive for real estate investments.
Private Equity and Venture Capital
Regarding private equity and venture capital investments, a higher IRR is typically expected due to the inherent risk involved in these investment types. The IRR in private equity and venture capital can be influenced by company performance, exit strategy, and market conditions.
Usually, an IRR between 20% and 30% is considered good, although top-performing funds may deliver even higher returns.
What Factors Influence IRR?
#1. Cash Flow Timing
The IRR calculation is sensitive to both positive and negative cash flows and the timing of these as well.
An investment with earlier positive cash flows tends to have a higher IRR. In contrast, investments with later positive cash flows and earlier negative cash flows will typically have a lower IRR. Therefore, it is essential to consider the cash flow timing and amount when evaluating investments based on IRR.
#2. External Factors and Market Conditions
External factors and market conditions also play a crucial role in determining the IRR of an investment. Factors such as interest rates, inflation, and economic conditions can affect the overall investment performance and influence the IRR.
For instance, if the market conditions are favorable and the interest rates are low, then the IRR of an investment will be higher. On the other hand, if there is economic uncertainty or the interest rates are high, the IRR might be lower.
IRR Real Estate Example #1
Here’s an example of how two different investments can return the same amount over the same period but have different IRRs based on differences in distribution schedules.
For example, let’s say you invest $120,000 into two different real estate investments over a 6-year period. One starts generating positive cash flow in the 3rd year (Property A), while the other doesn’t start until the 5th year (Property B).
At the end of 6 years, when they each sell, both return a total of $190,000 on your initial $120,000 investment at different times. However, property B offers a slightly lower IRR because it generates cash flow later than Property A.
Property A | Cash flow | Property B | Cash flow
Year 1 | $0 | Year 1 | $0
Year 2 | $0 | Year 2 | $0
Year 3 | $3,000 | Year 3 | $0
Year 4 | $6,000 | Year 4 | $0
Year 5 | $8,000 | Year 5 | $5,000
Year 6, | $173,000 | Year 6 | $185,000 |
*Note in Year 6, both properties sold
IRR on Property A: 10.432%
IRR on Property B: 10.265%
IRR Real Estate Example #2
Let’s look at a more simple example than the one above: Dr. Smith wants to teach his teenager about the IRR and states he will give him $80 to invest.
The investment generates cash distributions of:
- $10 in year 1
- $40 in year 2
Next, the investment is liquidated at the end of the 2nd year, and the initial $80 is returned. The total profit is $50 ($10 year 1 + $40 year 2).
The simple division would indicate that the return is 62.5% ($50/$80). However, since the time value of money (two years in this example) affects the return, the IRR is only 28.07%.
If his son had received the $50 profit and the $80 investment returned all in year 1, then yes, the IRR would be 62.5%. However, the return percentage went down since the cash flow was spread over two years.
Analyzing Real Estate IRR
Cash-on-Cash Return vs IRR
In my experience, evaluating a good internal rate of return (IRR) in real estate investing requires considering various factors. One such factor is the differentiation between cash-on-cash return and IRR. While cash-on-cash return measures the annual return on the initial capital invested, IRR considers the time value of money and the overall return on an investment over its holding period.
To help you better understand the distinction, consider this example:
- Cash-on-Cash Return: You invest in a rental property that generates an annual net cash flow of $10,000 with an initial investment of $100,000. In this case, the cash-on-cash return would be 10% ($10,000 ÷ $100,000).
- IRR: To calculate the IRR, you’d need to consider the projected cash flows for each year during the holding period and the eventual sales proceeds from the property. In this scenario, the IRR may be higher or lower than the cash-on-cash return, depending on how the property’s value changes over time.
Ultimately, weighing both metrics when evaluating real estate deals is crucial, as they provide different perspectives on the investment’s profitability.
Real Estate Syndications
Real estate syndications involve pooling resources from multiple investors to acquire a larger property that may be out of reach individually. As a passive investor, I may invest in these syndications as a limited partner. In these investments, general partners manage the property, make investment decisions, and provide investors with a projected IRR.
Usually, the general partners’ goal is to achieve an IRR that meets or exceeds the investors’ expectations. The IRR projection helps me, as an investor, assess whether a particular syndication aligns with my investment goals and risk tolerance. However, it’s essential to note that IRR projections are just that—projections—and actual returns can differ.
If you want to learn more about real estate syndications, check out this video:
Evaluating Real Estate Deals Based on IRR
When it comes to evaluating real estate deals based on IRR, consider following these general guidelines:
- Understand the market: Research local market conditions and trends, as they can significantly impact the IRR. Higher appreciation rates and rent growth aid in achieving a higher IRR.
- Assess the property’s potential: Dig deeper into the property’s attributes, such as location, amenities, and new developments, to gauge its potential for generating the projected cash flows.
- Scrutinize the assumptions: Analyze the assumptions made in the IRR projection, including income growth and exit cap rates, to ensure they align with my expectations and market reality.
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What Are The Limitations Of IRR?
When interpreting the Internal Rate of Return (IRR), it’s important to be aware of its limitations. As a metric, IRR might not accurately indicate profitability or project desirability, as it’s sensitive to the assumed reinvestment rates and does not take into account the actual investment size or distribution of cash flows.
Also, it’s essential to remember that past performance is not always indicative of future results. You must be mindful while using IRR, considering other metrics like the annual rate of return, to make well-informed investment decisions.
Frequently Asked Questions
What factors determine a good IRR?
A good IRR depends on various factors, such as the project’s initial investment, expected future cash flows, and the rate of return. When comparing investments, the higher the IRR, the more attractive the investment opportunity. However, IRR should be always analyzed along with other financial metrics to make well-informed decisions.
How does investment duration affect IRR?
Investment duration has a significant impact on IRR. Shorter-duration investments typically generate higher IRRs than longer-duration investments because the annualized growth rate would be higher if a project generates its net cash flow in a shorter time. However, it’s important to consider other factors, such as potential risks, cash flow patterns, and the opportunity cost of capital.
Are there industry-specific benchmarks for IRR?
Yes. Different industries have unique risk profiles, growth prospects, and capital requirements, which affect IRR expectations. For instance, a high IRR might be expected in industries with high growth potential and risk, such as technology or biotech. In contrast, lower IRR benchmarks would be more common in stable and low-risk industries like utilities.
How does IRR compare to other financial metrics?
IRR provides an annualized rate of return that considers the time value of money, making it valuable for comparing different projects and investments. However, it has limitations and should be used along with other financial metrics, such as net present value (NPV), return on investment (ROI), and payback period, to comprehensively understand an investment’s potential.
What role does risk play in evaluating IRR?
Investments with higher IRRs often involve higher risks, as investors expect a higher return to compensate for potential losses. Assessing the risk-adjusted IRR can offer better insights into the actual attractiveness of an investment opportunity. This can be done using techniques like the Sharpe ratio or risk-adjusted performance measures to compare investments with different risk profiles.Join the Passive Investors Circle