Read on Twitter
IRR remains the most utilized return metric in commercial real estate.
Most people know IRR as the discount rate of a project when NPV = 0.
But
What is IRR really made up of?
Read on for a breakdown of IRR in real estate investment analysis:
Most people know IRR as the discount rate of a project when NPV = 0.
But
What is IRR really made up of?
Read on for a breakdown of IRR in real estate investment analysis:
IRR can be derived from five sources.
1. Initial Investment Recovery
2. Year 1 Cash Flow
3. Cash Flow Increases Year over Year
4. Appreciation
5. Principal Loan Balance Reduction
Definitions of each below:
1. Initial Investment Recovery
2. Year 1 Cash Flow
3. Cash Flow Increases Year over Year
4. Appreciation
5. Principal Loan Balance Reduction
Definitions of each below:
1. Initial Investment Recovery
Purchase Price - Loan
It's crucial to at least be able to recover the initial equity you put into a deal.
Purchase Price - Loan
It's crucial to at least be able to recover the initial equity you put into a deal.
2. Year 1 Cash Flow
NOI - Debt Service - Capital Expenditures
This is simply the cash flow during the first year of the model.
NOI - Debt Service - Capital Expenditures
This is simply the cash flow during the first year of the model.
3. Cash Flow Increases Year over Year
Year “x” Cash Flow - Year 1 Cash Flow
4. Appreciation
Residual Sale Price - Sale Costs - Purchase Price at Acquisition
Appreciation relies on cash flow increases and exit cap rate assumptions.
Year “x” Cash Flow - Year 1 Cash Flow
4. Appreciation
Residual Sale Price - Sale Costs - Purchase Price at Acquisition
Appreciation relies on cash flow increases and exit cap rate assumptions.
5. Principal Loan Balance Reduction
Initial Loan Amount - Loan Balance at Sale
This amount increases as debt service is paid down.
Initial Loan Amount - Loan Balance at Sale
This amount increases as debt service is paid down.
It's best to break down the percentage of IRR coming from each source to fully utilize this concept.
Two deals with identical IRRs may have completely different allocations to these five sources.
Below is an example:
Two deals with identical IRRs may have completely different allocations to these five sources.
Below is an example:
After performing this analysis, Deal A has 40% of IRR allocated to appreciation while Deal B has 25%.
This means a substantial portion of Deal A's IRR is reliant on the asset appreciating, which holds more risk compared to Year 1 Cash Flow or Initial Investment Recovery.
This means a substantial portion of Deal A's IRR is reliant on the asset appreciating, which holds more risk compared to Year 1 Cash Flow or Initial Investment Recovery.
Remember, the IRR for both deals is the same at face value.
Now you can start to see the value in breaking down IRR into these five sources.
After recording the allocations for more and more deals, you'll start to see patterns emerge that can help you make better decisions.
Now you can start to see the value in breaking down IRR into these five sources.
After recording the allocations for more and more deals, you'll start to see patterns emerge that can help you make better decisions.
I can't take credit for this idea, but I found great value in this blog post from @HoffmanIke so I wanted to share: https://www.tacticares.com/blog-feed/properly-analyzing-the-irr-in-real-estate-investing
He also breaks it down in a helpful video:
