What is the Internal Rate of Return (IRR)? It is one of most popular metrics in commercial real estate, mainly because it focuses on one key element...the time value of money. In technical terms, the IRR is defined as the discount rate at which the net present value (NPV) of cash flows is equal to zero. In layman's terms, you can consider the IRR as an annualized rate of return.
While other metrics such as The Equity Multiple, Cap Rates, or Cash-on-Cash returns are also commonly used, the IRR provides insight into the timing of cash flows and how they compare to other investment opportunities.
IRR Calculation
In an effort to simplify the actual calculation of IRR, because not many of us are manually calculating given the power of Microsoft Excel, we will jump straight to the point and not overcomplicate the calculation.
In excel there are two functions that you can use to calculate the Internal Rate of Return, the IRR and XIRR functions. While both will get the job done, we prefer the XIRR function as it can account for the timing of cash flows based on the dates provided.
In comparison, the IRR formula will assume you only have one cash flow period per year, which is unrealistic in the world of CRE. More times than not, projects will have several distributions in a given year. This is where the XIRR formula steps in. The XIRR formula allows you to factor in the exact dates that cash flows are realized.
Excel Example
The example below highlights the main benefit of an IRR calculation. Both deals have the same total cash flow amounts, but Deal 1 is a 5-year hold while Deal 2 is a 10-year hold.
Without the IRR calculation an investor would look at the two deals and think they are the same caliber. With the IRR calculation an investor can quickly see their rate of return is much higher in Deal 1 due to realizing the same cash flows in half the time of Deal 2.
This is why we recommend using a combination of metrics to fully analyze a project. When The Equity Multiple, IRR, Cap Rates, and Cash-on-Cash metrics are used together, they can provide a full insight into a specific deal and allow you to get a better understanding on what return metrics to expect.
IRR Quick Points
How to calculate: IRR or XIRR functions in excel, XIRR is preferred
We prefer the XIRR function as it can account for the timing of cash flows based on the dates provided
Technical Definition: Discount rate at which the net present value (NPV) of cash flows is equal to zero
Layman's terms: Consider the IRR as an annualized rate of return
IRR focuses on the time value of money and provides insight into the timing of cash flows
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