Mastering IRR as a Passive Investor in Syndications

Real life investments have expected cash flows that are complicated and difficult to compare (Figure 1). IRR provides a convenient way to determine which investments are prefer able from the standpoint of the growth of your capital. As an added bonus, once you understand IRR, you will be able to confidently invest in a syndication as a passive investor. You will need to master IRR to understand the cash flow and capital event waterfalls that determine how investors get paid in these deals.

Figure 1. IRR isn’t rocket science! This article will teach you how to (easily) calculate IRR using a spreadsheet program. You can easily get miles ahead of other investors by learning to do the things that others refuse to do!

A Gentle Introduction Using (Very) Simple Math

Suppose you were offered two investment opportunities. Both require the same principal investment of $100,000. The first has a return on investment (ROI) of 25% and the second has an ROI of 100%. What should you do to determine which investment is better? You should ask “how long is my money tied up?” Suppose that the fist investment returns $125,000 one year from the date of investment and the second returns $200,000 but requires five years to return your money. In the case of the first investment, your rate of return is obviously 25%. But what about the second investment? The second investment yields only 14.9% per annum! You would be much better off taking the “quick nickel over the slow dime” and getting $25,000 for a one year holding period and then reinvesting that money over the next four years. Of course, the preference for the first investment is based on the assumption that you can find an investment that will produce $75,000 on your principal of $125,000 over four years, which represents an annualized rate of return of 12.4% compounded yearly (Figure 2).

Figure 2. A quick nickel beats a slow dime. A 25% gain in one year beats a 100% gain in 5 years by a wider margin than you might imagine. If you take the investment on the left, you would only need to make 12.4% on your money annually over the next four years to do as well as you would with the investment on the right.

Additionally, there are many things we will not be able to cover in this article including the impact of inflation, the effects of taxation on your wealth (and the advantages of deferring taxation) and the fact that the most important part of any investment analysis is quantifying the risk to your capital and the likelihood of the upside materializing.

Internal Rate of Return (IRR) IRR calculates the total return of an investment by finding the discount rate that sets the present value of all cash flows equal to zero. Another way to think of this is that it finds the rate of return capable of producing the stated cash flows. Before computers, this was a laborious, “guess and check” affair. Nowadays with spreadsheet programs, it is a cinch.

IRR is particularly useful for judging the total lifetime return of an investment. Some of the less sophisticated gurus will tell you that “once you return 100% of the cash invested, you have an infinite rate of return”. If only it were that simple. One might ask such gurus, if you are receiving an infinite rate of return, why aren’t you infinitely wealthy? Once you master IRR, you will know better, and what’s more, you will be able to properly calculate your return on these investments. An investment that can continue to provide a reasonable cash flow after returning your principal may be a great investment, but as we will see, it is certainly not infinitely so!

Now you know better, you can use the IRR to calculate the rate of return in these situations. IRR is far from perfect, it does not take into account inflation and only you can determine whether a particular investment is desirable given the expected return and the risks involved. Study the formula below to develop an intuitive understanding of IRR. If the formula doesn’t make intuitive sense to you, take heart, in practice, you will generally be using a spreadsheet to calculate IRR.

IRR – A (Reasonably) Realistic Example Involving a Syndication

Now that we have gone through the formula and a simple example, we can examine a more complex example that illustrates the true value of IRR. In our prior examples, we had a single cash flow that is analogous to a zero-coupon bond. We could have arrived at the same conclusion using much simpler methods such as compound annual growth rate (CAGR). When we have multiple cash flows that vary over the course of the investment, you will find a more robust method such as IRR to be very handy. The following example will serve to illustrate.

Suppose that you have a simple syndication waterfall in which investors whom we will call limited partners (LP) get a cumulative 8% preferred return and a 70% / 30% split of cash flow after their capital is returned to the LP and general partners (GP) respectively. A total of $1,000,000 of equity is raised and a 60% LTV loan is obtained to cover the rest of the transaction. Suppose you invest $100,000 in this deal. After the first quarter of this hypothetical deal, no $2,000 distribution is paid (one-quarter of 8% of $100,000). But, after the end of the second quarter, the project is doing well enough to catch up by paying not $2,000, but $4,000. Thereafter, the $2,000 quarterly distribution is paid on time.

After two years, many units have been renovated and with improved operational efficiency, the property’s value has increased by $1,000,000. The operators refinance the property at a 60% LTV which nets the project $600,000. Since you invested 10% of the total capital, you would see 60% of your capital returned at this point.

Fast forward to the end of the fifth year. The property is sold with net proceeds (after satisfying the refinanced loan) of $900,000. The first $400,000 completes the return of capital to the investors, of which $40,000 flows to the LP who invested $100,000. The remaining $500,000 will be divided between the LP investors ($350,000) and the GP team ($150,000) based on the 70 LP / 30 GP split. Our hypothetical LP investor in this example will net 10% of the $350,000 for a total $35,000. Since the capital was not returned until the end of the quarter, the full $2,000 preferred return will also be due.

To use Microsoft Excel ® to solve for IRR, start by listing the cash flows. If your cash flows are strictly annual, you can take the shortcut of using the IRR formula. If your cash flows are anything other than annual, you will need to use the XIRR formula which allows you to specify the timing of the cash flows. In our case, the cash flows will be on a quarterly basis. We will need a column to list the times that the cash flows occur as well. The formula used in the example below is “= XIRR(B2:B22,C2:C22)”. In this formula, the first column specifies the cash flows, the second column specifies the dates (Table 1A).

Table 1A. IRR can be rapidly and conveniently calculated using Microsoft Excel®.

Note that the timing of the cash flows is a key determinant in the magnitude of the final IRR. If the refinance cash flow is received one year later because of delays in construction, the IRR sinks from 18.7% to 16.4% (Table 1B).

Table 1B. IRR sinks from 18.7% to 16.4% if refinance is completed after three years.

If the refinance can be completed two quarters earlier (the quarter after the repositioning) because you use a local lender that does not require seasoning, the IRR increases from 18.7% to 20.3% (Table 1C). Clearly, in finance, as in other facets of life, velocity makes a big difference!

Table 1C. IRR climbs from 18.7% to 20.3% if the refinance is completed after eighteen months.

To make the determination whether you need to refinance and continue to hold or sell depends on many factors. The best way to approach this question is to continuously re-underwrite your deal under various scenarios during the holding period, not just under two scenarios as in this article. You will want to model these scenarios out after asking several questions such as: What sort of rent and or price appreciation do you expect during the holding period after refinance? What is the likelihood that the market will turn against you in the next x years? What rate of return was promised to investors? When do I begin to earn the promote? Your reward will be maximizing the likelihood of obtaining the highest return. 

Conclusion

One of the best ways to get ahead quickly is to master tasks that other investors find difficult or “boring”. IRR is only difficult so long as you don’t understand it! You now have a powerful new tool in your toolbelt!

This article examines two simple examples, a comparison of two investments with a single cash flow at the end and a simple syndication involving a 70% / 30% split. In practice, syndication waterfalls may be much more complex, although many syndications are as simple as the one described in this article.

Disclaimer

The information provided in this article is believed to be accurate but not guaranteed to be so. The author is neither a lawyer nor a CPA. The legal and tax landscape is an ever-moving target. You are encouraged to consult legal and tax professionals in all of your real estate dealings. The author is not responsible for any damages that may result from following or not following the advice in this article. All returns are hypothetical and are not intended to indicate “actual” or “expected” returns.