IRR Calculation vs others

Crystal H. · 2021-06-04T03:59:38-07:00

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

Carrollton, TX · Member since 2015 · 415 posts · 371 votes

5y

@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

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Lane Kawaoka

Rental Property Investor · Honolulu, HAWAII (HI) · Member since 2011 · 4k+ posts · 2k+ votes

5y

IRR is the Internal Rate of Return. This can often get confused with the return on investment and cash on cash because over the period of one year, all these percentages are the same. IRR specifically takes the time value of money and calculates what the average return is over a period of time and annualizes it. Say you put that 10k in and made 7% per year for 5 years and compounded it each year that equate to a 7% IRR for those 5 years precluded that your 10k was returned to you at the end of the period. When looking at real estate we know that very seldomly does an asset perfectly return an exact percentage and typically the asset grows in value over the time period. This calculation can take that expected growth and growth in cash flows combined into one metric to look at the investment.

Personally, I don't really look at IRR because it is a highly manipulated metric. Showing an unrealistic refinance in year 2 instead of year 3-4 will likely turn a 13% IRR deal to 16-17%. Magic! The best way to explaining this is for you to download an IRR calculator spreadsheet or build your own simple one and play around with one.

For what its worth most deals I deem meeting minimal IRR standards is 13-15% but you have to dig a little deeper to uncover the real placements of cashflows and capitalization events... and then dig even deeper to verify the assumptions such as occupancy, rent increases per year, and what reversion cap rate was used.

Again I don't look for IRR cause its manipulated a lot instead I look at total return on a 5 year basis. Its like sampling a NFL players 40 yard dash but for apartment underwriting. I'm sure there are other ways to do it but weather its right or wrong... I try to be consistent and I'm just trying to go in and pick the best in the field.

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Jonathan R McLaughlin

Rental Property Investor · Boston, Massachusetts (MA) · Member since 2016 · 2k+ posts · 2k+ votes

5y

ultimately IRR and similar metrics are shorthand for "how am I likely to do with this property?" You won't actually know until you sell or hold over the very long term. You can have 20% cash on cash for 6 years and year 7 the thing could burn to the ground and your insurance company refuse to pay then your tenants sue you.

So the result will only be as good as the accuracy of your assumptions permit, but IRR and the like are important tools to model various scenarios and gauge your risk/return using the information you have today and your best guesses for the future.. Ideally, you do this constantly. So...what would your return look like if interest rates reset at X + 3%, what would they look like if rent increased by 50% or if rent decreased and appreciation increased? Not sure thats likely but you get the idea, think of these formulas as a process not a "one and done"

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IRR Calculation vs others

IRR Calculation vs others

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