Is IRR still relevant for smaller investors?

Question

Hey Everyone!

Currently reading "What every real estate investor needs to know about cash flow" by Frank Gallinelli. Fantastic so far! I actually understand what IRR is! Been practicing running the numbers on some duplexes in my area on Google Sheets, good stuff. As I kept reading, however, Frank explained how the actual calculations behind IRR assume that all cash flow coming in is being reinvested at the determined IRR. This felt disheartening. I had finally found a metric that allowed me to play with the timing of selling and different magnitudes of cash flow and easily see how it would effect the IRR. I ran some numbers for properties in my area and the numbers were looking fantastic! However, I am only just beginning my real estate journey, I'm still waiting to do my first deal. I certainly will not be able to reinvest my cash flow anywhere that would yield the same rate of return, rather I would be saving all of my cash flow to invest in another property down the line.

My real question here is whether or not IRR is still a good metric for me to analyze properties with. Of course I will consider Cap Rate and CoCR as well, but this one seemed like the kicker. If the money isn't being reinvested as the cash flows come in like the calculation assumes, is it still a good metric for me personally? What if I saved the cash flow for 2-3 years and used it to obtain another property that would THEN start yielding the same or similar rate of return? Are those 2-3 lost years of reinvesting the cash flow not too significant to totally dismiss the accuracy or usefulness of my IRR?

The book does talk about the Safe Rate, but I don't have the kind of money to use that.

Sorry if this was long-winded or confusing. Would really appreciate any insight. Thanks all!

Steve Morris · Answer

CapRate = TODAY as a measurement of NOI vs Price.  You can use it as a comparative metric IF you have REAL operting numbers on all.  Just taking CapRates at face value may mean diff guys reporting them diff ways

Cash-cash = TODAY as a measurement of your return on cash out of pocket and has the same issues getting real numbers as CapRate.  You can use it to compare your investment to other yielding investments for your cash.  However, you'll need to figure out some sort of risk-adjust.  Comparing an apartment to a T-bill requires different levels of risk.

Both of these are a snapshot of today which you know.  If you want to forecast returns based on your confidence in price appreciation and income growth:

IRR - FORWARD-LOOKING.  Here you look at the return on a stream of forward looking cash flows, starting with your DOWN, then each period looking at your CFBT and finally when you sell your net proceeds.  Biggest issue is how accurately you can predict the future.  I guess if you're comparing properties with the same assumptions you can make it more valid.

Chris Seveney · Answer

@Eric Lilly

If you are dealing with single family properties most do not use IRR. If you are dealing in large complex MF properties with a capital stack it will come into play or if you are investing in mortgage notes as well

Whatever method you use, stay consistent but remember every method is wrong. What I mean by that is it is an estimate and what you need to be focused on is the data that goes into your calculation as it’s garbage In garbage out. If your figures are not accurate it doesn’t matter

IRR is also very good at comparing investments and whether you should sell to acquire a new asset.

As others mentioned I use a modified IRR which has money reinvested at a lower rate.

Shafi Noss · Answer

Hi Eric, nice work catching the subtleties of the metric.

IRR is an interesting, exactly equal to appreciation if there are no cashflows, and exactly equal to CoC if there are even periodic cashflows, and like you said it assumes cashflows are reinvested at the same rate which runs the risk of overestimating your returns.

One solution is to use the Modified Internal Rate of Return (MIRR) it assumes that cashflows are reinvested at a special reinvestment rate that you choose, like if you took the payouts and put them into bonds. There are some risk subtleties there, but that will account for the reinvestment error.

Another is to remember that IRR is measuring the return you are making, on different amounts of money over time. For example if you are making a 15% IRR and there is an early refinance where you pull out half your investment, remember that you're making 15% on only half of your investment and the other half is out of the picture. I wouldn't recommend this because multiple cashflows make it unruly very quickly.

My favorite method is to break it down. IRR is trying to cram cash flow and appreciation into one number. Just calculate the CoC, separately calculate yearly returns, and you'll have a clear picture of what the investment is doing.

Make sense? I think you're on the right track.

Cameron Whitehead · Answer

Eric, I understand all those metrics but rarely use them as a determining factor when I purchase. I just go off cashflow if it cashflow $150 a door and the down payment is manageable at the time then I go for it. Knowing all those metrics are good but find one you are comfortable with and take action.