Elementary IRR Question

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Elementary IRR Question

Julie N.
Member since 2020 · 11 posts · 0 votes

I told myself I wanted to have a firm grasp on IRR and have been researching online. I feel like it's easy to over complicate this and I've confused myself unfortunately :)..

The definition of IRR being the discount rate that makes NPV equal to 0 makes sense to me. The concept of NPV and discounting cash flows makes sense to me. What I don't understand is when IRR is referred to as a compounding annual rate of return.

I read this example and it threw me off.. "Abel sells land for $20,000 that he bought 4 years earlier for $10,000. The internal rate of return was 19%. That is the annual rate which compound interest much be paid for $10,000 to become $20,000 in 4 years"  

What about a scenario with multiple cash flows? For instance with an investment then with 5 years cash flows yielding 26.9% IRR.

($957,900) ,     $87,964,       $112,892,        $131,070,      $119,800,      $2,336,368,   26.95576%

Shouldn't you in principal be able to compound $957k annually by 26.9% and arrive at the same total amount as the total of the cash flows received over the hold? In the example above I know I am missing something as the total of the cash flows is $2.788M vs the simple compound interest of $957,900 over 5 years at 26.9557% is $3.159m.

Thanks for helping me clear this up!

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Brian BurkePro Member
Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
6y

Simple answer, @Julie N.!

In your compounding example, you are assuming that all of the earnings remain in the investment, meaning they compound each year at the same annual growth rate as the principal.  This would be true in a savings account where you took no withdrawals, for example.

IRR, on the other hand, measures cash flows. So in your IRR example you are showing cash flow every year, which means that money is distributed to you and there is no compounding on the distributed dollars because they are no longer in the investment.

If you run your IRR calculation like this (the same way you are using your compounding example), the IRR would be 23.8219%. Same dollars in, same dollars out, different timing.

-957,900, 0, 0, 0, 0, $2,788,094 = 23.8219% IRR

Or, you could run it like you did in your compounding example, using the compounded earnings (more dollars out, same % IRR as the % compounded):

-957,900, 0, 0, 0, 0, $3,159,236 = 26.9557% IRR

The lesson here is that you need to re-invest your earnings, or accept that the same IRR will give you fewer dollars than a comparable fully-compounding investment if you get any cash flow. Probably a good trade-off because you might want to use that money for something else.

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  • Brock Mogensen
    Real Estate Syndicator · Milwaukee, WI · Member since 2018 · 1k+ posts · 907 votes
    6y

    This is a good scenario and I don't have the exact answer for it. IRR can get pretty complicated. I find the easiest way to understand the calculation is to map it out in Excel. Once I can view it in a spreadsheet the calculation always makes much more sense to me.

    0Reply
  • Julie N.
    OP
    Member since 2020 · 11 posts · 0 votes
    6y

    Thanks for the response!

    0Reply
  • Julie N.
    OP
    Member since 2020 · 11 posts · 0 votes
    6y

    @Brian Burke I read your book and it was hugely helpful. Any insight here is greatly appreciated!

    0Reply
  • Nick Peters
    Specialist · New York City, NY · Member since 2019 · 399 posts · 168 votes
    6y

    Hi @Julie N.,

    If you test it on excel, you'll see that IRR = CAGR (compounded Annual growth rate) if there is no intermediary cash flow. When your project generates cashflow in intermediary periods, then your IRR will start to differ from a compounded annual growth rate (which always assumes a one-time initial investment and a one-time final payout). That's what you're observing in your two examples.

    0Reply
  • Brian BurkePro Member
    Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
    6y

    Simple answer, @Julie N.!

    In your compounding example, you are assuming that all of the earnings remain in the investment, meaning they compound each year at the same annual growth rate as the principal.  This would be true in a savings account where you took no withdrawals, for example.

    IRR, on the other hand, measures cash flows. So in your IRR example you are showing cash flow every year, which means that money is distributed to you and there is no compounding on the distributed dollars because they are no longer in the investment.

    If you run your IRR calculation like this (the same way you are using your compounding example), the IRR would be 23.8219%. Same dollars in, same dollars out, different timing.

    -957,900, 0, 0, 0, 0, $2,788,094 = 23.8219% IRR

    Or, you could run it like you did in your compounding example, using the compounded earnings (more dollars out, same % IRR as the % compounded):

    -957,900, 0, 0, 0, 0, $3,159,236 = 26.9557% IRR

    The lesson here is that you need to re-invest your earnings, or accept that the same IRR will give you fewer dollars than a comparable fully-compounding investment if you get any cash flow. Probably a good trade-off because you might want to use that money for something else.

    Podcast Guest on Show The Truth About Real Estate Investing in 2024 (What Investors NEED to Know)
    4Reply
  • Bob Dreher
    Novato, CA · Member since 2013 · 52 posts · 28 votes
    6y

    @Brian Burke has perfectly illustrated the difference between IRR and CAGR...since IRR assumes cash out to invest, then the timing of cash back distributed over time...without any consideration for the additional return which may be generated by the investment of the amounted received through periodic distributions. This allows investors to compare apples to apples when anaylizing different investment options.

    CAGR calculations may include things like stocks, or money market holdings which offer a reinvestment option...or other compounding investment options...generally reliant upon the options one may choose pursuant to their individual reinvestment return into which distributions are invested over the total investment period.

    So, in order to make CAGR assumptions, one must assume the return generated by periodic distributions of real estate, which may be used to generate future returns over the holding period.

    1Reply
  • Julie N.
    OP
    Member since 2020 · 11 posts · 0 votes
    6y

    Thanks for the clarification this makes a lot of sense. So a good definition of IRR is an annualized compounding rate of return that takes into consideration the timing of periodic cash flows but does not make any assumption about the reinvestment return of income distributions over the hold?

    0Reply
  • Julie N.
    OP
    Member since 2020 · 11 posts · 0 votes
    6y

    Does IRR assume reinvestment at the IRR rate for another investment or not then?

    0Reply
  • Steve Morris
    Real Estate Broker · Portland, OR · Member since 2019 · 4k+ posts · 2k+ votes
    6y

    Realize that IRR is usually forward looking (you create it to decide if something is a good investment). It is supposed to reflect an "average" rate of return.

    For something like a T-bill, if you pay $1000 for it (year 0), get 5%/year for 7 years (years 1-7) and then get your $1000 back (year 8), you're earning 5% as a RR.

    However, rental property earns income 2 ways - Operating profits and price appreciation.  The cashflows would be your down pmt (Year 0),  CFBT each year (years 1-x) and then proceeds (year x+1) = Sale price - debt bal - costs of sale.

    More confusing, for the same IRR, you may get a diff total cash return depending on when you make your money. Using both examples

    • You buy an apartment for $400 in Year 1, in years 2-5 you make $15 net income. In year 6 you make $20 income and year 7 you sell the apartment for $800.
    • You buy a T-bill for $400 in year 1. Years 2-6 you collect interest only payments and in year 7 you sell the T-bill for $400 and collect another interest-only payment

                                                      Year                                                                            

                             1           2        3          4         5        6         7         IRR    Sum CF

    Apartment $(400.00) $15.00 $15.00 $15.00 $15.00 $20.00 $800.00 14.929% $480.00

    T-Bill          $(400.00) $59.72 $59.72 $59.72 $59.72 $59.72 $459.72 14.929% $358.30

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  • Steve Morris
    Real Estate Broker · Portland, OR · Member since 2019 · 4k+ posts · 2k+ votes
    6y

    "Does IRR assume reinvestment at the IRR rate for another investment or not then?"

    IRR only reflects the return on a series of cash flows.

    If you're doing a historical, you can supply the numbers and go to a XLS and easy calc.

    If you do forward-looking, you estimate the returns and calc a IRR.

    You use IRR to compare properties based on how much return to expect. Idea is the higher return is a better choice. However, IRR is only ONE metric when deciding on a property.

    1Reply
  • Nick Peters
    Specialist · New York City, NY · Member since 2019 · 399 posts · 168 votes
    6y
    Originally posted by @Julie N.:

    Does IRR assume reinvestment at the IRR rate for another investment or not then?

    IRR indeed assumes that the project's cash flows are reinvested at the IRR rate. Because that's often not the case in real life, an adjusted IRR, called Modified IRR (MIRR) is also available in Excel. The key difference is that it allows you to specify your own reinvestment rate in the formula, which is very useful for real estate investments.

    2Reply
  • Julie N.
    OP
    Member since 2020 · 11 posts · 0 votes
    6y

    @Nick Peters does your statement contradict Brian’s on this point regarding reinvestment?


    ”IRR, on the other hand, measures cash flows. So in your IRR example you are showing cash flow every year, which means that money is distributed to you and there is no compounding on the distributed dollars because they are no longer in the investment."

    0Reply
  • Nick Peters
    Specialist · New York City, NY · Member since 2019 · 399 posts · 168 votes
    6y

    @Julie N.

    I'll let him clarify his statement but I confirm mine: IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the reinvestment can be the same project or a different project). Therefore, IRR overstates the annual equivalent rate of return for a project that has interim cash flows which are reinvested at a rate lower than the calculated IRR. That's the whole point of MIRR which lets you decide of this reinvestment rate.

    For more details, you can check "IRR vs MIRR" on google, there are a few good articles about that subject.

    0Reply
  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    6y

    Totally agree with @Nick Peters. I took the first CCIM in the early eighties and learned that the ITR does in fact assume year,y cash flows are reinvested at whatever overall IRR results. It was suggested instead to use the FMRR (financial management rate of return) in which you could plug in realistic short term reinvestment rates for the yearly cash flows..

    0Reply
  • Bob Dreher
    Novato, CA · Member since 2013 · 52 posts · 28 votes
    6y

    @Julie N. @Brian Burke is absolutely right...

    ”IRR, on the other hand, measures cash flows. So in your IRR example you are showing cash flow every year, which means that money is distributed to you and there is no compounding on the distributed dollars because they are no longer in the investment.

    When calculating real estate investing...The Internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested. No additional return on the amount distributed is assumed once the distribution has been made. IRR uses a dicounted cash flow to Net Present Value...so future periodic cash flows are calculated to arrive at an IRR, but only discounted from the future point at which they are distributed.










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  • Julie N.
    OP
    Member since 2020 · 11 posts · 0 votes
    6y

    Are there differing opinions here then on the reinvestment portion or am I so confused that I can’t tell everyone is saying the same thing lol

    0Reply
  • Bob Dreher
    Novato, CA · Member since 2013 · 52 posts · 28 votes
    6y

    @Julie N.    No, I don't think everyone is saying the same thing...I think it really depends on what you are trying to accomplish with your ananlysis...

    Discounted cash flow works backwards (not forward)...discounting future cash flows distributed (from the date distributed) to Net Present Value (NPV) . This will be used to calculate your IRR...

    What is does not calculate is the return which may be generated on the distributed cash until the original investmentamount is fully wound down...that requires a more complex calculation. You can certainly do this...but has nothing to do with your original request for "Elementary IRR Question..."

    If you choose to calculate a total return projection over the entire investment period (including periodic distribution with reinvestment), then you need to calculate your return differently.

    Hope this helps (a bit)

    0Reply
  • Brian BurkePro Member
    Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
    6y
    Originally posted by @Julie N.:

    @Nick Peters does your statement contradict Brian’s on this point regarding reinvestment?


    ”IRR, on the other hand, measures cash flows. So in your IRR example you are showing cash flow every year, which means that money is distributed to you and there is no compounding on the distributed dollars because they are no longer in the investment."

    Julie, Nick and I are saying the same thing. Your original question essentially boiled down to "why do I get more money with a compounding return than I do with the same IRR if IRR is supposed to be a compounding return?"

    I said you get less money because you received cash flow and didn't earn a return on the cash you received, so you get less money. Nick says you have to invest the cash you received at the same rate as the IRR in order to have the same dollars earned (as compared to a straight compounding return) once it's all over. Same thing said in two different ways.

    Remember what IRR is most useful for: comparing one real estate opportunity against another, because the cash flow (in both directions) and the timing of the cash flow, varies from one opportunity to another and IRR provides a way to quantify that performance. It's somewhat less useful in comparing real estate investments to other investment strategies.

    Podcast Guest on Show The Truth About Real Estate Investing in 2024 (What Investors NEED to Know)
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  • Julie N.
    OP
    Member since 2020 · 11 posts · 0 votes
    6y

    Thanks everyone! 

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