Illuminating the nuances of IRR
Understanding the return profile of an investment opportunity
As a real estate investor, you’re probably always on the lookout for the best returns. And if you’ve been in the game for a while, you’ve likely come across the term ‘IRR’ more times than you can count.
But what does IRR really mean, and is it the ultimate indicator of an investment’s potential? Is it always the best strategy to invest in offerings with the highest IRR?
These are the questions I found myself grappling with throughout my own journey as a real estate investor. Over the years, I’ve evaluated hundreds of offerings and gained an understanding of return metrics the hard way: through trial and error, and making mistakes firsthand. In fact, these experiences formed the motivation behind founding Elmbase — a platform designed to help others navigate their investment journey.
In this blog post, I hope to impart some of these insights, particularly around evaluating the return projections of investment offerings.
Let’s dive in!
This post will focus on return metrics in the context of real estate syndication. If you’re new to the concept or want a refresher, I recommend reading my previous blog post first.
AAR vs IRR
Real estate syndication investment opportunities often provide an estimated return on your capital in the form of an AAR and/or IRR estimate.
AAR (and equity multiple)
Equity multiple, also called MOIC (multiple on invested capital), is simply the total cash distributions received, divided by the total capital invested. For instance, if you invest $100k and get back $200k over time, your equity multiple is 2.0, since you’re doubling your money. As an investor, your goal is to maximize the equity multiple of your portfolio across a given timeframe.
Is an equity multiple of 2.0 good? Well, that’s a trick question. What if it takes you 100 years to get that return? Or 1 year? Of course, equity multiple by itself tells you nothing about the quality of a return if you don’t know the term of the investment.
Enter AAR.
AAR, or average annual return, is the return generated divided by term (number of years), expressed as a percentage. In the aforementioned example, your return would be $100k ($200k–$100k). If it took 4 years to generate this return, then your AAR is 100/4 = 25%. Pretty good!
But what if instead of getting the full return in the final year, you got your original capital returned back to you in the first year — ie $100k back at the end of year 1, and then the last $100k at the end of year 4? The AAR of the deal still remains the same, 25%, but you now have $100k in liquidity at year 1 that you can reinvest to generate even more returns (ie double dip!). By the end of the 4 year term, you could end up with a higher equity multiple on your original capital than 2.0 — even though technically, the AAR on your investment is still 25%. How can we capture this benefit?
Say 👋 to IRR.
IRR lets us favor a return in which the same dollars are returned sooner, so that you could potentially invest it elsewhere and grow your capital even faster. It takes into account the time value of money; that is, that a dollar today is worth more than a dollar tomorrow.
IRR
IRR stands for internal rate of return. For the sake of understanding, let’s explore IRR from an investor’s perspective; ie under the context in which you are already given an IRR estimate for an opportunity. We’ll explore how to calculate IRR in the Appendix.
Think of IRR as the annual compound interest rate that your investment earns across all future cash flows. Imagine breaking down your initial investment into several portions, with each portion being returned to you at distinct future times. Each of these portions grows at a compound interest rate that equals the IRR of the investment.
Stated another way, the IRR for an investment is the percentage rate earned on each dollar invested for each period it is invested.
Note that as each portion is returned, the principal amount still actively compounding in the investment decreases.
This means that, if you want your overall portfolio to continue compounding at the same rate as the investment’s IRR, you will need to redeploy that capital into a similar returning investment.
Let’s illustrate with an example. Suppose an offering has a 20% IRR with a 2 year term. Let’s look at a few different scenarios with different cashflows.
Scenario 1 — Year 1 and Year 2 distributions
Say your $100k investment is working for you in two $50k chunks, and the first chunk is returned to you in year 1 and the last chunk in year 2.
You’d end up with $132k at the end of year 2, with an equity multiple of 1.32x. AAR in this scenario is 16% (0.32/2 * 100%).
Note how AAR (16%) is lower than IRR (20%) in this scenario.
Scenario 2 — Year 2 distribution only
Let’s massage some numbers! Let’s say instead of two chunks working for you, you just have a single distribution at the end, with the same 20% IRR. Let’s see what happens.
Here, we end up with $144k and an equity multiple of 1.44x (up from 1.32). Our AAR for this offering would thus be 22% (up from 16%).
In this scenario, AAR (22%) is higher than IRR (20%), even though IRR remains the same. Equity multiple is higher as well — so you’d ultimately end up with more cash in your bank. The only thing that’s changed is the timing and amounts of the cashflows. In scenario 1, after the first year, half your original capital is pulled out and is no longer working for you at the 20% compounding interest rate; the principal left in the deal still compounding has decreased. In scenario 2 on the other hand, your dollars are working for you for more time before being returned; hence the higher final equity multiple.
IRR tells you nothing about equity multiple (and therefore, cash in your pocket) — you need to understand cashflows to give you a full picture.
Furthermore, note that knowing IRR doesn’t mean you can calculate AAR — and vice versa (a common misconception). In fact, we’ve seen how IRR can be both greater than, and less than AAR, depending on cashflows.
So, which is better? The second option gives you a higher equity multiple at the end of the 2 years — 1.44 vs 1.32 — meaning you end up with more cash in your pocket. At first glance, this seems better. But the first option gives you some capital back sooner, giving you liquidity; and in theory, you could take that and re-invest it into another deal.
Scenario 3: Scenario 1 With Reinvestment
Let’s take scenario 1 again, and this time, let’s say you take your year 1 distribution of $60k, and immediately invest it in another 20% IRR, 1 year deal:
Here, in year 2, you get $72k from the first deal and $72k from the second deal back, for a total of $144k. Thus resulting in an equity multiple of 1.44x, and an AAR of 22%.
This results in the exact same overall returns as scenario 2, just spread out over two deals! In this scenario, similar to scenario 2, all your money is working for you for the entirety of the two years at the same compound interest rate of 20%, thus, the final returns are identical.
So let’s ask again: which one of these two scenarios is better?
Well, your goal as an investor is to maximize your portfolio’s value. Both scenario 2 and scenario 3 give you the same final equity multiple. And your capital is tied up for 2 years in both as well. However, in scenario 3, you get liquidity at year 1, and diversification across two deals, so your eggs aren’t all in one basket. Of course, this comes at a cost: you have to go through a bit more overhead to find, vet, and manage your money in the second deal. (Side note: you can use Elmbase to help with this; join the waitlist today to organize your portfolio and discover deals.)
If you consider both deals to be equally risky, then I’d argue scenario 3 is superior. Despite the overhead in managing two deals, it’s better to diversify, and you get a liquidity option at year 1 (in case you need it for another purpose).
Recap
Armed with this context, let’s return to our original questions:
Is it always the best strategy to invest in offerings with the highest IRR?
Let’s give a concrete example, and, for fun, add some nuance: would you rather take a deal that gives you 100% IRR over 1 year, or 20% IRR over 10 years?
Traditional thinking says that IRR is how we compare deals, and the higher the better. However, assuming both deals are equally risky, I suggest taking a more nuanced approach: consider cashflows, opportunity costs, and your liquidity preferences. Remember: your goal is to maximize equity multiple of your entire portfolio across a given timeframe, while minimizing risk. You want your dollars maximally working for you, actively for as long as possible.
IRR doesn’t give us the full picture for this, so we’ll need to dive deeper. When are both deals projecting to distribute funds back to you? Do you want liquidity in the short term, either for your own consumption, or for redeploying into other, similar opportunities, if they’re available?
If the 100% IRR deal gives you back an equity multiple of 2.0x (ie one lump sum return after 1 year) and you believe there are other 20% IRR investment opportunities available after 1 year, then it’s better to take the first deal, since you can juice the 100% return for the first year, then get 20% over the last 9 years.
On the other hand, in the extreme case, if the 100% IRR deal gives you back an equity multiple of 1.08x (ie returns 1 month after you invest, then some nominal amount at the end of year 1, resulting technically in a term of 1 year), then I’d suggest asking yourself whether it’s truly worth taking on the risk of parting with your capital for just 1 month of meaningful returns. Furthermore, if there aren’t other compelling opportunities at that time, then you may be sitting on cash uninvested for a while, as you wait for a deal to come along. In this scenario, it’s perhaps better to invest in the second deal to lock in the 20% IRR for a 10 year period.
However, there are some additional considerations for the second opportunity. Let’s say the deal gives you your return at the end of the 10 year period, netting you a sweet 6.2x equity multiple. If we compare the two deals in isolation, assuming no other deals available, this one looks better (6.2x > 2.0x). But, do you really want that much of your equity tied up for that long in a single offering? Realistically, other opportunities will be available, and it’s generally better to diversify across multiple investments, to mitigate idiosyncratic risk.
Is IRR truly sufficient to understand how lucrative an investment opportunity really is?
Hopefully you know the answer by now 😄. IRR helps you compare different opportunities; but you still need to understand what the projected cashflows / equity multiple are in order gage how lucrative an opportunity really is.
Don’t just hunt for deals with the highest IRR. At the risk of sounding like a broken record, understand the cashflows, as well as the estimated equity multiple. Only these together give you a sense of the return profile of an offering.
And of course, it’s also not just about picking the deal with the highest IRR or equity multiple. Do you agree with the operating statement, market study, financing strategy, and the assumptions being made? What are the risk factors and do you believe they’re being adequately mitigated? What are the cashflows, and how do they fit in with your liquidity preferences? (If you’re interested in a deeper dive into the intricacies of evaluating real estate syndication offerings, let me know in the comments.)
And perhaps the biggest factor of them all: do you trust the sponsor and their track record?
At Elmbase, we’re committed to demystifying real estate syndication, equipping you with the tools needed to manage your portfolio, grow your network, and evaluate offerings.
If you’d like early access, feel free to sign up for the waitlist here.
Til next time!
-Ajay
CEO and Founder, Elmbase
Appendix
Now, let’s flip the script: how do sponsors compute IRR for an opportunity, given a series of cashflows (contributions and distributions)?
Computing IRR given cashflows
Before we can understand how to compute IRR, given a series of cashflows, we first need to understand present value and net present value.
Present value
Fundamentally, a dollar today is worth more than a dollar tomorrow. Therefore, if we want to compute the present value of a future dollar, we need to discount it by some factor.
Given a discount factor of r, the present value PV of some future cashflow CF at year t is:
For instance, suppose we receive $100k in 1 year. If we assume a discount factor r of 25% (ie we think that a dollar today is worth 25% more than a dollar next year), then the present value of that future $100k is given by:
So, we would consider having $80k today as the same as $100k in 1 year, assuming a 25% discount factor.
Net present value
Of course, we usually have more than one cashflow and they can be in both the positive (distribution) and negative (contribution) direction.
Summing all of these gives us the net present value, given a discount rate r:
So, NPV is simply the sum of all the present values of all inflows (ie distributions, considered as positive present values) and all outflows (ie contributions, considered as negative present values).
Intuitively, projects that result in a positive net present value given a discount rate are worth undertaking — and the higher the NPV, the better the opportunity.
In this context, the discount rate can be considered a “baseline” by which an investment’s return must exceed in order for it to be worthwhile. For instance, one may set a discount rate to the target inflation rate (3%). Or they may set it to their opportunity cost to investing in other assets, such as US treasury bills (~5.5% at the time of writing), or the stock market (say, ~10%, representing the average annual S&P return over the past 30 years). If an opportunity yields a positive NPV given the set discount rate, then it’s a good opportunity.
What if we don’t want to make any assumptions about the discount rate; we have a series of cashflows, and we want to compute the IRR of an opportunity?
Calculating IRR
Intuitively, the IRR of an opportunity is simply the discount rate at which the NPV is zero. This means that, given the cashflows of the opportunity and a discount rate equal to IRR, the NPV is neither telling us to undertake or pass on the opportunity — it’s telling us that the opportunity is hitting the baseline discount rate that we’ve defined, which is the IRR.
So if we want to compute the IRR for a given set of cashflows, we just set NPV equal to 0:
And then solve for the discount rate r.
Let’s do an example. Revisiting our scenario 2 from above:
We calculate the present values of each and set to 0:
You’ll generally need a calculator or an Excel formula to solve for IRR / r. Plugging this into a calculator and solving for r, we get r=0.2. We can plug this back into our NPV and verify that it indeed equals 0.
