Basic finance questions about IRR

[Ron Vered]

Hello!

I'd like to ask the following general investment questions regarding real estate investment. This is while I am trying to analyze my potential first real-estate deal.

Please correct me if I am wrong, but it seems to me that IRR is this wonderful single number which I can use to compare my RE investment to investing in the stock market or any other type of investment. It basically gives me the annualized interest rate of my investment. So, if in this world I'd invest in this opportunity and there was a parallel universe where I invested in the same amount of money in something else entirely, I can easily compare the 2 investments based on their IRR. Furthermore, if the 2 investments had the same cash flow at the same time, from the time of investment until the time of sale, then they shall have the same IRR.

However, of course, as I cannot predict the future and since I also cannot even predict taxes, I thought of estimating IRR without taxes, hoping it will not be that different from an alternate stock market investment. Alternatively, a real-estate professional has given me some estimated numbers for taxes, for a revised IRR (which is lower).

I also understand that forecasting exact expenditures + their timing is hard yet can impact the IRR's accuracy. Perhaps not enough to obscure the picture.

Q1: Is it correct to do an IRR estimation and compare it to the stock market performance? The exact number is not exact, but close enough estimation?

Q2: When you do CoC calculation, especially for the next 10+ years, you omit growth in equity (property appreciation + reduction in loan balance). Why then do it? How do you compare it to other, non real-estate investments?

Q3: What are good and realistic IRR values to aim for?

Thanks,

Ron.

[Bill Gulley]

Sorry, but Q1. is a NO!

IRR measures returns of LIKE investments, carrying similar financial and market risks, of similar liquidity an other risks. Real estate is unique and is not comparable to stocks or bonds or annuities or commercial paper purchased on an auto dealership! Your alternative investments become apples and oranges.

Can you go further with economic comparisons beyond the IRR? Yes, but you will need to factor in influences risks, degree of management and costs of holding assets, investor's time, experience and knowledge being similar, differences in liquidity, marketability of the asset as well as growth or appreciation expectations.

If you compare a SFD to a SFD, or a multifamily to like properties or a strip mall to another, the investments are similar but they can not be compared equally to IBM stock, or a municipal bond or an annuity from Prudential or any other private obligation.

Which also addresses Q2. And, CoC is a use of cash performance ration, not an asset ratio not a liquidity ration or an equity ratio. It only measures the best use of cash when used with alternative investments as to the before tax return on cash invested. Again, you have the same issues as to types of investments. Actually, it's not that meaningful in reality and it is a short term indicator, not a good long range assumption for pro-forma analysis.

Then, what is a good IRR? Heck, when used properly the higher the better! You may get personal opinions.

A good investment is not that simplistic, since real estate is unique, you need to look at several aspects, capital requirements to get in, management costs (financial and economic headaches), liquidity, marketability, appreciation, tax benefits and there may be intrinsic benefits. Intrinsic benefits might be your ability to use a property as additional collateral in another transaction, it might be some community benefit that makes you a hero in your community, good will, or generating other business opportunities.

A good investment is one that doesn't cost much to get into, doesn't present headaches, that cash flows to pay for itself, doesn't eat any hay, and appreciates in value! There is no ratio for that and it will be different for each investor. 

I use 10% as a capitalization rate in many circumstances, as costs to enter a transaction or deal increase, the time/management increases, any risk increases, that may go up to 15%, tax effects may take my requirement higher too. But, an acceptable capitalization rate for valuations in real estate is usually 10%, the minimum generally required by similar investors.

Call an appraiser in your area, just ask them, when using the income approach to residential real estate valuations, what do you consider an acceptable capitalization rate? They should be able to answer that without holding their hand out for money. But don't ask them to defend it as it is an opinion, not a factual ascertainable rate among area investors!

And, you never know how your real estate will perform until after the fact, future numbers are a best guess, historical numbers are real. Good luck playing with your calculator. :)