What Is IRR and Why Is It So Important For Investors?
Finance is math applied to money. For the investor, a basic working knowledge of financial math goes a long way in comparing different investment opportunities. But for most, the nomenclature of finance can seem daunting. Probably the most mystifying of all the financial ratios is the IRR, or the Internal Rate of Return. Not only is it one of the more opaque of the financial calculations that go into investment analysis, it is arguably the most important metric to understand in comparing like investments.
The IRR is included in the Investment Summary of just about every syndication deal regardless of the underlying asset. So, you can run from the IRR, but you cannot hide. It’s time to face it head on. It is one of several metrics that an investor must consider in the decision of whether to buy into an asset or not. Let’s look under the hood at a simple investment and see how the IRR can be helpful in comparing similar investment options.
Consider two investments that return the same amount of cash but in two different ways. Suppose an investor puts $100,000 into Multifamily Deal A and expects a return of $200,000 in 5 years. The investor receives the initial capital back of $100,000 plus a profit of $100,000. Even this would be strange for a Multifamily Deal, for the purpose of this illustration, let’s assume there are no cash flows in years 1-4. In Multifamily Deal B, the investor invests $100,000, but instead of waiting 5 years before seeing a profit, the investment begins paying $10,000 in years 1-5.
Both investments return the same amount of cash in the end. Both have an Average Return of 20% because there is $100,000 of profit divided over the 5 years ($100,000/5 = $20,000 or 20%)
Now let’s consider the Internal Rate of Return of both investment options.
IRR Defined: IRR is the percentage return of dollars invested in the period in which they are invested.
The IRR equalizes both deals to a Net Present Value of zero for the purposes of comparing the two investments. In other words, the IRR factors in the time value of money and places a value on investments that return money back to the investor faster. This is valuable for the investor because the cash can be reinvested in other projects thus accelerating the growth of capital.
We can see the MF Deal A has an IRR of 15%, while MF Deal B has an IRR of 17%. Based on this metric alone, Apartment Deal B is the preferred investment. You can see now why IRR is so valuable. If one looks at Average Return or ROI alone you can see how the analysis suffers. The IRR adds the dimension of evaluating the investment based on the time value of money. Deals that provide higher cash on cash returns earlier in the deal will show a higher IRR. The same is true for cash-out refinances or supplemental loans that repatriate cash back to the investor. This is why investors in multifamily deals like to see syndicators with a history of these investment actions when doing diligence on syndicators. Syndicators realize their performance will be evaluated by savvy investors based in part, on their IRR so they are keen to hunt for deals that present opportunities for high IRR’s.
Obviously, as apartment investors we need to consider other factors in our diligence process such as the market, track record of the deal sponsor, and the business plan for the asset.. No one metric should be used solely to make an investment decision, but the IRR does help us compare like assets that present different uneven cash flows.