Investors have traditionally relied on the annualized rate of return (ARR) to make decisions when calculating their returns on investment. However, the addition of internal rate of return (IRR) has created a new “must-know” metric for investors looking for greater clarity.
In this post, you will learn about IRR, what is a good IRR for real estate, and how it can provide more significant insights into your investment decisions in the real estate industry.
IRR stands for “Internal Rate of Return.” It is the interest rate earned on all capital sources over an investment’s lifetime. It represents returns from an investment over multiple periods and considers both positive and negative cash flows. It is common in real estate to use it to analyze development projects.
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AAR vs. IRR in Real Estate
Similar to the development example above, AAR and IRR are two different metrics that present different interpretations of the same data. Investors typically use AAR to compare projects and IRR for investment decisions.
Real estate fund management firms will consider these metrics when calculating cash flow reports available to limited partners (LPs). In fact, there is no one size fits all approach to analyzing capital structure due to differences in local market conditions and the variables involved with real estate investments.
The bottom line is that each real estate property is unique, and there is no one-size-fits-all when it comes to analyzing the cash flow of investments. AAR will show you the deal’s profitability averaged over time, while IRR is the rate you would receive based on all sources of capital (debt and equity) from an investment.
What is a good IRR for real estate?
IRR is one of the most effective tools for analyzing real estate investments. By using it to compare properties or lending terms, investors can clearly understand the value of their investments and make better decisions. The right answer to the question “what is a good IRR for real estate” is 12 to 15 percent.
Using IRR in real estate
IRR can help a real estate investor determine whether or not an investment should be pursued. However, it can also provide insight into the performance of a certain real estate project over time. Here are some common uses:
Cash Flow Analysis
When analyzing cash flow, IRR can help determine a good deal by looking at the total returns over time. The higher the rate, the more “revenue” was created at that point. If a property loses money, decreasing occupancy rates will only cause it to decrease since less money will be created.
Project/Property Comparison
Using IRR as a metric for comparison can provide investors with various perspectives of projects or properties. For example, a property management software solution can allow you to calculate multiple scenarios and view them side by side for comparison and analysis. This can be helpful when looking to improve project performance.
Real Estate Development
IRR is the metric investors will use to make decisions on development projects. In fact, many lenders and other financial institutions will require the internal rate of return calculation to close on a loan.
Lender Analysis
Using IRR, you can develop a view of the returns earned by lenders over time by looking at cash flows and the interest rates charged for debt capital. Few things drive lender performance as much as interest rates over time. When comparing lender performance, it is essential to consider longer-term returns and net interest margins that may be affected by significant prepayment or loan modification activity.
Conclusion
Real estate investors should use IRR when making investment decisions. It compares the returns against all types of capital (debt and equity) over time. Using it with other metrics such as AAR, NOI, COC, and cash flow analysis provides a complete description of the performance of a real estate property.
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