A common metric used to evaluate investment performance in multifamily real estate and often compare various investment opportunities is the Internal Rate of Return (IRR).
When reviewing investment opportunities from multifamily sponsors, IRR is one of the projected returns that should be shown. IRR is expressed as a single percentage, such as 15% or 17%, for the entire project.
The significance of IRR is that it factors in the time period of the investment.
Most multifamily real estate investments have a holding period of 3-5 years or more. An initial sum of money is invested and held during this period, and various amounts of cash are distributed during this time, including the initial sum invested and hopefully a profit at the end when the property is sold.
Therefore, simply calculating the return on investment for each individual year does not give a complete picture of the investment’s performance.
This is because those profit distributions and return of invested capital may vary from year to year, being higher in some years and less or even absent in others. And since the time value of money (TVM) tells us that $10,000 received in the first year is actually worth more than $10,000 received at the end of 5 years, then we need to account for this TVM factor in order to get a more accurate picture of investment performance.
The goal of IRR is to do just that, by providing an estimated annual rate of return that takes into account not only the amount of cash flows and equity, but also the time period over which the money is invested and returned.
The technical definition of Internal Rate of Return is the discount rate at which the net present value of all cash flows equals zero.
But again, a simpler description of IRR is the estimated annual rate of return on the investment based on cash flows, equity, and time.
In order to calculate IRR, we need the following information:
- initial capital invested
- annual cash flows
- holding period
- equity profit when the property is sold
While the actual mathematical formula for calculating IRR can be complex, modern software has made it relatively simple to plug in the numbers and get to the estimated IRR of an actual or potential investment.
At the end of an investment period, once the property is sold and the above factors are known, then determining the IRR in retrospect can be pretty straight forward.
However, when evaluating a potential new investment and looking forward to project the IRR, these values are estimates based on assumptions.
IRR is an important measure of investment performance when reviewing potential real estate opportunities. IRR projects the estimated annual rate of return on the investment based on cash flows, equity, and time.
Projecting IRR requires that we have pretty good assumptions about the numbers we plug in, including our projected cash flows, number of holding years, and projected property value at the time of sale. Being conservative in these estimates is always recommended when analyzing potential investments and projecting returns.
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