Understanding the IRR
When first evaluating commercial real estate investment opportunities, it is important to understand the projected internal rate of return (IRR). The key component is to understand the difference between the deal level IRR and the net IRR projected to the limited partner (LP) investors.
The projected deal level IRR is the return based upon the cash inflow and outflow at the property level. While the deal level IRR may look good to a passive investor, it does not reflect the actual return that the investor expects to receive, because it does not reflect sponsor fees and the waterfall structure.
The net IRR return to the LP investors is very important to understand. It reflects the actual projected return to the investor and factors in the profit split that the general partner (sponsor) is proposing to take.
The IRR also incorporates the “time value of money,” which provides the investor with a better analysis of the return on investment. The underlying time value of money concept is simply the idea that a dollar today is worth more than a dollar tomorrow. This is true for three reasons including inflation, opportunity cost of another investment, and the risk associated with the possibility that the dollar will not be in fact returned to the investor.
In the IRR calculation the value of future money must be “discounted.” This is a concept that works similar to compounded interest. The value of a future money earned is linked to how a present dollar earns a return. This includes the idea that a distribution paid in later periods is paid on both that initial investment dollar and the distribution earned in earlier periods.
One drawback of the IRR calculation is that it assumes earlier cash distributions are reinvested at the same rate of return, which depending upon the investor, may not be the case. That said, the IRR calculation is a very good indicator of a real estate deals overall rate of return.
Fortunately, Microsoft Excel’s IRR calculator makes the computation of IRR easy. The IRR calculation in Excel allows the investor to use different sets of assumptions and projections to analyze the proposed investment. This functionality is crucial, since the IRR is merely a projection based upon a set of expected outcomes.
Understanding the IRR is merely a projected return based upon expected outcomes, reinforces the importance of passive investors in conducting proper due diligence on the deal sponsors.
Selecting the right deal sponsor is your most important decision. The deal sponsor can make or break the outcome of any investment.
