Is IRR a good metric for a multi-family investment?

Question

Hello all,

I am looking at a few multi-family opportunities and the other investors have sent me packages which use IRR.  Is that a good metric?  Are there other ones that may be better at evaluating an opportunity?  I know usually we speak about CAC, ROI or ROE.

Thanks,Sonny

Brian Burke · Answer

IRR is the most common metric for comparing one real estate opportunity against another, and in my experience it is the one that most investors prioritize.  Many investors take the easy route and glance at the IRR and form a conclusion in their mind as to whether the deal is good, or not.  This is a very shallow view, however.  There is so much more to it.

Most importantly is that an IRR forecast is only as good as the assumptions behind the forecasts in which the calculation is based.  Garbage in, garbage out, as they say.  It's critically important that you examine the underwriting and assumptions made in arriving at any particular performance projection to see if the projections make sense and are reasonably achievable.  Bad underwriting is the primary failure point for most IRR comparisons, and it makes it tough to make apples-to-apples comparisons across various sponsors/brokers/investors because some underwrite very reasonably, or even conservatively, others underwrite aggressively, and yet others underwrite as if they live on another planet.

Another consideration is that what is desirable to you in an investment dictates which performance indicator to focus on most.  If you are most interested in cash flow and don't care much about capital growth, Cash-on-Cash return is a better meter to focus on.  If you are more interested in growth, and not interested in cash flow, equity multiple could be the focus, if you couple that with hold period timing.

There's no absolute answer that covers everyone, but what IRR does is it takes into account the amount of cash flows, the direction of cash flows, and the timing of cash flows to quantify results that you can then compare to other similar options.  Just be sure you focus less on the number and more on how that number was calculated.

Marjeanne Fields · Answer

We look for what we call the "holy trinity". This is 12% Cash on Cash. 1.6 DCR (Debt coverage ratio) and min 7% Cap Rate. The IRR will change based on how long you hold the property. We always look to give our investors 17-21% IRR.

John Sayers · Answer

All good responses! To add to the debt, look at the type and term of debt too. Different risks profiles. IRR can be confusing to some and misleading to many. Best used only as a soft indicator.  A multiple is much harder to fudge.

Alina Trigub · Answer

@Sonny Sach

Depending whether you’re active or passive investor, you maybe looking at different metrics. Also depending on how aggressive your investment strategy your expectations for each metric will differ.

Additionally, I t’s important to evaluate the IRR in conjunction with other metrics. And equally important as @Brian Burke indicated to examine the underwriting assumptions.

Hopefully this article will shed more light for you on some of the other metrics: https://www.biggerpockets.com/member-blogs/10850/79257-deciphering-syndication-investment-terminology

Best!

Chris Grenzig · Answer

@Sonny Sach IRR is equivalent to an annualized return, except it takes into account Net Present Value (NPV) of money; or that a dollar today is worth more than a dollar tomorrow.

High level, if you gave someone a 15% annualized return in cash flow every month for 3 years and no back end sale proceeds, your IRR and annualized return would be 15%, because it was 15% always.

If you did have of that in cash flow (7.5%) and made up the difference on the back end sale at the end of year 3 (22.5%), you would still have an annualized return of 15%, but you're IRR would be LESS because it took 3 years to get the extra money instead of throughout the entire period.

I haven't done the math to be honest, so in the first example they may not be exactly the same, but they will be almost the same where as the 2nd example there could be a couple percentage points difference between the Annualized Return and the IRR.

It's because it takes into NPV that IRR is generally regarded as one of the more important metrics when comparing different investments because in incorporates the length of hold to achieve the desired return.

Tj Hines · Answer

@Sonny Sach A good metric to pay attention to along with the IRR would be the Debt service coverage ratio and CoC returns especially if you’re leveraging equity with debt. Banks minimum for DSCR is 1.25. Where we are in the market you may want to be at least a 1.35-1.5     1.25 covers the banks tail not yours. Anywhere from 8-12 % CoCR is suitable over the life of the investment. Then again where the market is guys are getting into plays that feed off 6-8%. Just really depends on who is leading the deal - who and what type of investors they are catering too; syndication that is. Whatever you do in a tight contracting market you wanna protect yourself by relying on solid fundamentals.

David de Luna · Answer

Do your own IRR. This will force you to decide when you will exit, or decide on an exit date you'll use for all your calcs, research the actual property apprciation trend, and rental increase history for you market. Then you will know how your IRR is derived. Otherwise you have no idea what criteria are used.

Lane Kawaoka · Answer

I don't look at IRR these days cause everyone is manipulating it by saying they are going to do an unrealistic refinance in year 2-3 which makes the IRR go up from 14 to 18% magically.

Sonny Sach · Answer

Thank you all, I really appreciate the feedback.  This community has been so helpful in my journey.

Is IRR a good metric for a multi-family investment?

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