Learning to learn and valuation metrics, Installment 3: The Internal Rate of Return

The Internal Rate of Return (IRR) is a critical financial metric used in real estate investment to assess the profitability of potential investments. It represents the annualized effective compounded return rate and is used to evaluate the attractiveness of a property or project. It gives important information about the real value of an investment over time, according to a specific business plan and the time period of a planned hold to sale or a specific future time point.

To calculate IRR in real estate, one must consider the initial investment, the projected cash flows over the investment period, and the eventual sale or residual value of the property.

The following statement is one I read often as the definition of IRR: “The IRR is the discount rate that makes the net present value (NPV) of all cash flows (both positive and negative) from a particular real estate investment equal to zero.” I find this description difficult to understand in conceptual terms. I would restate this in the following way: If we imagine that all profit and loss apply only to the value of a property at a specific future time point, what is the value of my initial investment? The IRR allows this kind of assessment because the rather complicated formula below includes some of the variables of the “time value of money”. Time value of money is the idea that money invested now is worth more than money invested in the future because of the relative loss of value in cash over time.

Time value of money is an important concept to understand for any investor. It is determined by loss of interest of non-invested money, the loss of value due to inflation, the loss of opportunity of investments that might exist but aren’t taken advantage of.

Another way of conceptualizing the IRR is to ask, what annual interest rate “r” can I expect from this real estate investment at future time point “x” if all profits are re-invested. If IRR at a particular future time point was calculated to be 0%, that would imply that the break-even point is at the future time included in the IRR calculation. In this way of thinking about the value of money over time, any returns over this are “true” profit. Thus, an IRR of 19% represents a 19% annualized return if all profits are reinvested in a property with predictable returns. As such, IRR becomes inaccurate if we are taking our profit (to pay investors, for example) or if profits cannot be reinvested with the presumed rates of return. In other words, an IRR of 19% is not the same as a savings account that returns 19% annually. In reality, if you could find that savings account, it would likely be a much better investment in terms of the money you would have at the end of a given time period, even if we don’t account for the risk of real estate investing versus a guaranteed savings account.

In this context, it is important to understand the variables included (and those not included) in the IRR, however, in formulaic terms, the IRR cannot be solved for directly by the type algebra most of us can conceptualize. The calculation requires solving complex polynomial equations with multiple cash flows. (And here we reach the limit of my knowledge of math. Suffice in to say that IRR is to some degree a leap of faith for those of us without math degrees 😉)

NPV: for IRR calculations we set this to 0. This is like asking “What is the value of the investment if we assume no profit?”.

CF0 = Initial cash investment

CF1, 2, …n : the cash flow over a given time period (CF1, 2 … n). The formula adds all these different cash flows together.

Finding the IRR requires iterative calculations, often done via financial calculators or spreadsheet software, as it's not a straightforward formulaic calculation. The accuracy of the calculation depends on the degree to which cash flow per time period, derived from a spread sheet including contributory variables to cash flow, is accurate and inclusive.

For my part, I interpret IRR based on a single model. While I change the variables in the model (spread sheet) I use to calculate IRR, I understand that that makes interpretation of IRR calculated in a different set of variables less comparable. The quality of the data out is only as good as that put in.

IRR is a powerful tool for comparing the profitability of different investment opportunities in real estate. A higher IRR indicates a more profitable investment. However, it should be used in conjunction with other metrics like cash-on-cash return, Cap Rate, and total return, as it alone doesn't provide a full picture of the investment's risk or other important factors like the investor's liquidity needs.

As I have said earlier in the series of blogs, I find the process of learning to evaluate properties in some ways similar to my experience learning the science of medicine. In the 20 +  years since I first started evaluating patients, I have developed an instinctual ability to consolidate hard data from lab values, physical exam findings, historical information from the patient and the patient’s record and arriving at something that is more than the sum of those data points, something intuitive and actionable. Having gone through this learning process, I see it happening now in my real estate education. The skin of the home, the line of the roof, the level of the floor, condition of the interior, impressions of a property inspector and analysis according the metrics described above paint a picture that is more colorful and meaningful than any one of the points of data alone. This leads to the kind of intuitive thinking, informed by experience and analysis, that allows creative personal and professional growth.