What is Internal Rate of Return (IRR)?

What is IRR (Internal Rate of Return)?

The Internal Rate of Return, or IRR, is one of the metrics commonly used in financial analysis to evaluate and compare different investments. It represents the percentage rate earned over a defined period of time, calculated on the basis of cash flows. IRR differs from other metrics in that it accounts for the concept of the 'time value of money', meaning it is calculated as the discount rate that makes the present value of all cash flows from an investment equal to zero. In more simple terms, it is the rate at which an investment grows or declines. In this sense, you can think of it as a time-sensitive compounded annual rate of return.

What Are Some Limitations to IRR?

IRR can be useful as an analysis tool, but it does have some limitations and shouldn't be used in isolation. One of the issues with relying solely on IRR to compare investment is that it can be misleading if used alone due to the data used to calculate it. Although a higher IRR might look good at face value, investors need to understand the factors used to derive IRR. It is also important for investors to understand that a return is not guaranteed.

How Can IRR Be Useful?

IRR can be a useful tool for comparing investments because it can provide an 'apples-to-apples' comparison of two cash flows with different distribution timing. To help illustrate the concept, consider the following three examples.

Examples of IRR

Example 1: The Coupon

The first example is an investment with regular distributions and no upside or downside participation and no fee upon sale. In this example, the investment is in a stabilized property that receives 10% annual distributions until the return of capital at the end of year 5 after the sale of the property.

Example 2: The Annual Pref with Upside

In the second example, we add in some upside on sale. In this case, the operational cash flows are still regular, allowing for 8% annual distributions; however, there is participation in the profits from sale in year 5.

Here, the IRR is the same as the first example - 10%. Despite receiving less cash during the first four years, the two investments accumulate returns over the 5-year term at the same rate. Notice that it takes more cash to achieve the same IRR. This is because of the time value of money.

Example 3: The Value-Add

In this final example, we replace the 8% annual distributions with irregular payments. Suppose the business plan is to renovate and re-tenant an office building. In the first year there is no operating income, and in years 2 and 3 half of the operating income is held in reserve for tenant improvements as the lease up occurs. The building reaches stabilization in year 4 and is sold in year 5. The distributions look like this:

Again, the IRR is the same as the first two examples—10%. Again, the investment accumulates at the same rate over the same time period despite having zero income in the first year and less income in years 2 and 3.

What Are Some Potential Issues with IRR?

As we've seen, there are ways to manipulate the IRR based on how it is calculated. For instance, a sponsor might present a project-level IRR; however, this rate of return is not an apples-to-apples comparison with a net-to-investor IRR because it does not take into account sponsor fees and promotes. In the cases where there are fees or promotes, the project-level IRR will be greater than the net-to-investor IRR, meaning the investor stands to receive less than what the project-level IRR might seem to represent.

For investment opportunities presented on Crowd Street, we do not feature projected IRR calculations, as we believe investors should holistically evaluate an opportunity and not solely rely on one calculation.

Learn more about investing in CRE in ourupdated commercial real estate guide.