IRR Calculation vs others

[Crystal H.]

I'm curious everyone's thoughts on using IRR to evaluate deals vs some of the other calcs that are seen more often.

As (new) buy and hold investors in our early 40s, my husband and I are far less concerned with what happens in the first 12 months of an investment and more concerned with the medium to long term horizon with our investments (5+ years.) I feel like using CoC is absolutely helpful on some level, but doesn't get to the end result of holding something over a long period of time and then realizing the benefit of it by selling in the future.

One answer as to why investors don't look at it as much is because I've read many people don't like to bank on any appreciation. However, when I'm deciding whether to invest in the stock market vs real estate, I sort of HAVE to take an educated guess at what the returns will be on each to make my decision. If I leave my cash in the stock market, I'm banking on X% return there, which is also a guess. And, when I'm doing an IRR calc, I'm extremely conservative (3%/year, even in this market.)

Another possibility is that it's too much trouble to forecast out and people are uncomfortable with the assumptions you have to make. Totally fair. I have taken a few personal finance courses in studying to get my CFP accreditation so am comfortable using these calcs and putting the time in to do them properly.

What is your take? Is anyone using IRR to evaluate deals? Very new to this world so could absolutely be missing something here... :)

[Immanuel Sibero]

@Crystal H.

As a relative newbie, I went through the same thought process as you are. After some years of reading about real estate, I started to develop some general guidelines to follow when it comes to correctly measuring performance in real estate, especially since I wanted to compare performances of other investments such as stocks, bonds, etc. It's important to start with identifying all possible returns that can be generated in real estate some of which can be subtle and easy to miss.

The four sources of return in rental real estate:
1- Cash flow
2- Loan paydown
3- Appreciation in value
4- Tax savings

Below are some metrics that are normally used and thrown around here on Biggerpockets, and what type of returns/performance they are designed to measure:

- CoC (Cash on Cash) is a measure of net return generated by TWO sources (i.e. Cash flow and Loan paydown) on an annual basis.

- Equity Multiple can be used to measure the net return generated by ALL FOUR sources (i.e. Cashflow, Loan paydown, Appreciation, and Tax savings) throughout the life of the investment. Equity Multiple does NOT take into account the time value of money. In practice, the effect of tax savings is usually not included because it can be complicated to calculate.

- IRR (Internal Rate of Return) can be used to measure the net return generated by ALL FOUR sources (i.e. Cashflow, Loan paydown, Appreciation, and Tax savings) throughout the life of the investment. IRR takes into account the time value of money. In practice, the effect of tax savings is usually not included because it can be complicated to calculate.

I use CoC and IRR at a minimum and I think IRR is a great comparative metric to use when I need to compare real estate to other type of investments.

NOTE: I do use other metrics which are not performance measure related such as 1%/2% rule, DSCR, Breakeven, etc. which help me anticipate potential cashflow problems if any. You will also run into CAP RATE which is very much misunderstood here on BP. Cap rate discussions almost always lead to lively exchanges primarily because many investors erroneously use it as a performance measure. But you're working towards your CFP, so you're good! :-)

Cheers... Immanuel