Return IRRegularities: Let’s Talk About Internal Rate of Return…
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." -Ben Graham
“I see all these return metrics on your presentation. There’s ERM… there’s CoC… there’s AAR… and there’s this IRR metric. Can you give me a refresher? What do all of these return metrics mean, again?” One of our potential partners asked me this the other day.
Let me first say that we are extremely thankful for our engaged audience. As you may have noticed, many of our recent posts were inspired by the incredible dialogues we have with “our tribe.” This is not intentional, but we do want to cover topics that matter on top of the topics that WE THINK matter.
We believe it is absolutely critical for our audience to understand the fundamental building blocks of real estate investing in order to fully comprehend areas of greater complexity. With our blog, we aim to cover it all. This blog series is YOUR RESOURCE.
Going back to the question. After thinking about it, we thought it would be helpful to provide our audience with insightful details on the return metrics we use in real estate. After the “essentials” are covered, we will dive deeper into one of those metrics.
The first in a series of blog posts related to investment performance measurement is internal rate of return, also known as IRR.
So let’s get started with the broader overview.
The “Essentials”
There are quite a few performance metrics in the investment industry, but to keep things simple, we will cover the ones that we believe to be the most common in our multifamily investment universe:
Average Annual Return (“AAR”)
Definition & Calculation: AAR is the average amount that is earned each year over a given period of time. To calculate AAR, you take the sum of the return rates of your investment over a specific number of years and divide it by the number of years. In our case, this number would almost always be shown in our presentations as net of fees.
Application: AAR is just another metric used by investors to look at the overall historical performance of a property investment, which is often used as a relative benchmark for the current or future (i.e. projected) AAR. AAR is most frequently measured over the life of the investment, but it is also common to measure over three-, five-, or seven-year periods.
This metric is helpful if an investor wants to know the potential investment's current annual return as compared to its historical return.
Some say that an attractive AAR is somewhere in the range of high teens to 20%+. This varies in our industry based on the amount of risk you are willing to take in a property investment.
It is important to remember that average annual return is not the same as average annual rate of return (i.e. annualized returns or the geometric mean of returns) -- this is an entirely different metric from AAR that factors in compounding.
Cash-on-Cash Return (“CoC”)
Definition & Calculation (CF Capital’s common use case for CoC): The metric is calculated using a formula that divides the property's annual net cash flow, after paying debt service, by the initial investment amount, and it is shown as percentage.
Application: CoC is one of the simplest approaches for measuring a real estate investment's performance. This metric can be split up over specific periods of the lifetime of the investment, but it is almost always used to reveal the performance over the life of the investment (i.e. entry to exit).
We should note that CoC as a return metric doesn't take into account the time value of money. In other words, when looking at the investment performance of two properties with the same CoC, there is no consideration for which property was sold first. The metric also doesn’t include the property’s appreciation (only after the property is sold).
Some say a good cash-on-cash return for our investment universe is 7-10% over the lifecycle of the hold period. But really it is subjective and depends entirely on the amount of risk taken.
Equity Return Multiple (“ERM”)
Definition & Calculation: The equity multiple on an investment is a metric that measures the total cash return over the entire lifespan of the investment. The formula is the amount at exit (i.e. total amount given back → distributions + total cash back at sale) divided by the amount at entry (i.e. initial investment amount). Note that this takes into account any fee deductions involved with the investment.
Application: You might also see ERM referred to as Multiple on Equity (“MOE”), Multiple on Invested Capital (“MOIC”), and Return on Equity (“ROE”). ERM can be shown as unlevered or levered, but in our case, we will always show ERM on a levered basis because our investments benefit in many ways by properly leveraging some sort of debt financing to amplify our returns.
One simple and easy way to think about ERM is to look at it as how many times you get your capital back on an investment. Many operators target an ERM of 2x, but this also is subjective and depends on the idiosyncratic risk taken.
As with the CoC return, the ERM’s drawback as a performance metric is the fact that there is no consideration for the time value of money. The multiple only shows how many times you multiplied your initial investment amount. This also means that the metric can easily be skewed if there were many cash inflows and outflows over the investment period (we can dig into this in a future post).
Internal Rate of Return (“IRR”)
Definition & Calculation: IRR is the rate (%) earned on each dollar invested for each period of time that it's invested. Some simply call this interest. But you may alternatively perceive IRR as the rate needed to convert the sum of all future cash flow to equal your initial investment. It sounds confusing, but it is nothing an excel spreadsheet can’t handle, we promise. The formula is shown as follows (setting the NPV to zero and solving for the discount rate, which is the IRR):
(Note that the IRR presented to our investors deducts any fees related to the investment.)
Application: IRR is a popular way to measure investment performance in real estate. IRR considers the time it took an investor to get back an initial investment and any of the investment profits.
Unlike the other metrics, the timing of when cash flow is received has a significant and direct impact on the calculated return (thus, it is dollar-weighted [aka money-weighted], taking into account time value of money). In other words, the sooner you receive cash back, the higher the IRR will be.
A “good” IRR often is considered to have a range similar to AAR (unintentionally); high teens to 20%+. But just like the other metrics, it is subjective and is dependent on risk. It is also dependent on so many uncertainties and when invested capital is actually returned to investors.
It is worth noting that IRR doesn't always equal the annual compound rate of return on an initial investment. An internal investment can increase or decrease over the life of the investment, and IRR does not account for what happens to capital that is taken out of the investment. Another flaw with IRR relates to the formula potentially producing negative returns in between the time of the initial investment period and the time of the sale, causing multiple results for IRR. This disruptive issue of negative IRR happens when the aggregate amount of cash flows caused by an investment is less than the amount of the initial investment.
The main thing our audience needs to remember is that no single measure is all-encapsulating and does not cover everything needed to assess a real estate investment. Multiple measures are needed to determine the performance of an investment.
A Deeper Dive Into IRR
Broadly speaking, the internal rate of return (“IRR”) is a metric used to estimate the profitability of investment by calculating the rate of return on each dollar invested for the time period when it was invested.
IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. IRR calculations rely on the same formula as NPV does, but it is not the actual dollar value of the project. It is the annual return that makes the NPV equal to zero.
Here are the items you “need to know” organized in bullet points:
General Use Case → To measure attractiveness of an investment.
General Rule for Judgment → The higher the IRR, the better.
Exception to the Rule → If cash flows back to the investor (i.e. inflows), including sale proceeds are early/quick, and the total return is not significant (e.g. ERM) .
Information Need to Calculate → Initial investment amount, size and timing of cash flows (including the cash proceeds from the sale, if there was a sale).
Advantages and Weighting of Return → Appropriate for those looking to measure performance of cash flows and the speed of the growth of the investment value. As a metric, IRR would be very helpful to use for budgeting, especially over longer periods of time. IRR is a Dollar- or money-weighted rate of return.
Limitations → Calculation is not as simple as other metrics and could result in multiple IRR values; IRR values are difficult to predict;
What else might be important to know?
As mentioned above, generally, the higher the IRR the better. Also, the IRR metric is a good way to compare the real estate investment in focus with benchmarks, such as other opportunities in the marketplace, or historical IRR’s for the respective investment universe. However, if the real estate investment resulted in realized profits very early and the IRR is skewed high, the total amount given back may or may not have been significant. One can find this out by calculating the ERM, which is explained above.
We realize that the formula and calculation process seem daunting, but we would be happy to walk you through it or provide you with a template to get a better, hands-on understanding.
Essentially what you need to know to calculate IRR is: 1) set NPV equal to zero and solve for the discount rate (i.e. the IRR); 2) The initial investment will always be negative because it shows an outflow occurred (i.e. an outflow to be invested in the real estate); 3) after the initial investment, each cash flow could be positive (an inflow) or negative (an outflow); 4) because of the nature of the formula, you must solve by trial and error or use software to do so (i.e. Microsoft Excel)
What’s the difference between compounded annual growth rate (“CAGR”) and IRR?
CAGR typically uses only a beginning and ending value to provide an estimated annual rate of return, IRR uses values in between the beginning and end, including the cash flows.
CAGR is a simple calculation while IRR is more dynamic.
Also, what’s the difference between return on investment (“ROI”) and IRR?
ROI measures total growth of an investment from start to finish in percentage terms (ERM in multiple terms), while IRR measures annual rate of return.
ROI is a simple calculation, involving the beginning and end value of the investment, but is not always as helpful for longer time periods and factoring in periodic cash flows and returns.
It is important for you to know the difference between IRR, and all the metrics mentioned above -- AAR, CoC, ERM, ROI, and,, CAGR. (We know… there are a lot of acronyms being “thrown around.”) By knowing the differences, you can tell when it is appropriate to use IRR as a return metric and you will be armed with the ability to properly analyze investment opportunities based on the projected return metrics.
——————————————————————————————————————————————————————
Interested in partnering with us? Join our investors list here.
