{"id":126,"date":"2019-10-26T06:09:48","date_gmt":"2019-10-26T11:09:48","guid":{"rendered":"https:\/\/33holdings.com\/learning-center\/?p=126"},"modified":"2019-10-26T06:18:16","modified_gmt":"2019-10-26T11:18:16","slug":"measure-your-returns-understanding-irr-in-private-equity-real-estate-investments","status":"publish","type":"post","link":"https:\/\/33holdings.com\/learning-center\/2019\/10\/26\/measure-your-returns-understanding-irr-in-private-equity-real-estate-investments\/","title":{"rendered":"Measure Your Returns : Understanding IRR in Private Equity Real Estate Investments"},"content":{"rendered":"
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Measure Your Returns : Understanding IRR in Private Equity Real Estate Investments<\/h2>\n

Note: Real Estate and Private Equity are specialized subjects that contain technical terms. To assist in the understanding of the subject matter contained in this Blog, we\u2019ve provided a glossary of key terms (in bold) at the end.<\/em><\/p>\n

When considering an investment in a Private Equity Fund and\/or Commercial Real Estate, one of the first questions that an investor may ask themselves is, \u201cIf I invest in this property, what is the return I can expect on my investment?\u201d<\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n

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IRR is designed to measure the compound annual rate of return an investor can expect on their investment\u2026<\/em><\/h3>\n<\/blockquote>\n<\/div>\n<\/div>\n
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For a real estate deal, there are a variety of ways to measure returns, but one of the most commonly accepted and <\/i>most misunderstood is called the\u00a0Internal Rate of Return<\/b>\u00a0or\u00a0IRR<\/b>.\u00a0 IRR is designed to measure the compound annual rate of return an investor can expect on their investment and we\u2019re going to discuss it in detail in this article.<\/div>\n<\/div>\n
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Note : The above picture is our own 33 Unit TownHome Project yielding IRR of 20%+ returns which is our target of return most of our value add projects strive to make. Check us out at http:\/\/www.33holdings.com<\/em><\/div>\n
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Calculating IRR<\/strong><\/h3>\n<\/div>\n<\/div>\n
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IRR is the rate earned on each dollar invested for each time period it\u2019s invested in.\u00a0 That second part of the definition is a critical one, \u201c\u2026for each time period it\u2019s invested in.\u201d \u00a0 There\u2019s a time component to IRR that can\u2019t be ignored because it accounts for the compounding of returns.\u00a0 IRR is often used as a proxy for the interest rate and mathematically speaking it\u2019s calculated as the rate of return that sets the\u00a0Net Present Value<\/b>\u00a0of all future cash flows (positive of negative) equal to zero.<\/div>\n<\/div>\n<\/div>\n<\/div>\n
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To illustrate this concept, consider the following series of cash flows.\u00a0 Assume a purchase price of $1MM, annual net cash flows of $50,000 and a sale for $1.2MM at the end of a 6 year\u00a0holding period<\/b>\u00a0(year 6 also has $50,000 cash flow).\u00a0 It looks like this:<\/p>\n

To calculate the IRR, it\u2019s easiest to put the cash flows in a spreadsheet and use the function for IRR to calculate the answer.\u00a0 Doing so returns the discount rate at which the NPV of this series of cash flows is equal to $0. It\u2019s ~7.7%.<\/p>\n

To check this, use the same series of cash flows with the NPV function.\u00a0 For the discount rate, use the answer to the IRR function and, if you\u2019re right, the answer should be $0<\/p>\n<\/div>\n<\/div>\n<\/div>\n

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Pros of Using IRR as a Tool for Measurement<\/strong><\/h3>\n<\/div>\n<\/div>\n
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As a tool for measuring the return on your property, there are several advantages to using IRR.IRR is a good metric to account for the\u00a0time value of money<\/b>, which is the concept that a dollar received today is worth more than a dollar received in the future, due to its earning potential.\u00a0 This is where the time component comes in.<\/p>\n

In addition, IRR is a simple metric that can be used to compare investments of a similar time horizon.\u00a0 For example, if you\u2019re trying to decide between three different properties with the same holding period, IRR is a good way to compare the return potential for each.\u00a0 This isn\u2019t just limited to comparing real estate investments, IRR can also be used to compare non-traditional investments (like real estate) to traditional ones like stocks or bonds, as long as the time horizon is the same.<\/p>\n

While IRR is useful, it isn\u2019t perfect.\u00a0 When using IRR, there are a few limitations to be aware of.<\/p>\n<\/div>\n<\/div>\n

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Cons of using IRR as a tool for Measurement<\/strong><\/h3>\n<\/div>\n<\/div>\n
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Remember the importance of time in the IRR equation?\u00a0 It contributes to one of the major flaws with IRR, it can\u2019t be used to compare projects with different holding periods.\u00a0 If you\u2019re comparing a real estate investment with a 5 year holding period to a bond investment with a 10 year holding period, IRR is useless.Further, IRR doesn\u2019t measure the absolute return on an investment.\u00a0 For example, a $100M investment that returns $105M in 1 month works out to an IRR of ~80%, which seems great.\u00a0 But, the absolute return is just $5M, which isn\u2019t as good.<\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n

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Lastly, IRR doesn\u2019t consider the\u00a0cost of capital<\/b>.\u00a0 Rationally, you only want to consider projects with an IRR that exceeds your cost of capital.\u00a0 If the project has an IRR of 10%, but your cost of capital is 15%, then the deal probably isn\u2019t worthwhile.For these reasons and others, IRR is best used as one of several metrics to compare investment opportunities.\u00a0 To illustrate this idea, let\u2019s look at an example.<\/p>\n<\/div>\n<\/div>\n

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Example<\/strong><\/h3>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n
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Year 0 cash flow represents a purchase price of $1MM.\u00a0 Because it\u2019s an outflow, it\u2019s shown as a negative number.\u00a0 Years 1-4 show a series of cash inflows based on the proforma and sale occurs in year 5.To calculate the Net Present Value of this opportunity, a discount rate is required.\u00a0 The discount rate that results in a Net Present Value of $0 is the internal rate of return.<\/p>\n

Rather than go through the complicated math of the calculation, it\u2019s easiest to use the IRR function in a spreadsheet to calculate the answer.\u00a0 The input would look like this:<\/p>\n

=IRR(Cash Flow 0, Cash Flow 1, Cash Flow 2, Cash Flow 3, Cash Flow 4, Cash Flow 5)<\/strong><\/h3>\n

The result is 14.78%.\u00a0 If the IRR exceeds the cost of capital by an acceptable margin than it\u2019s an indication that the project may be worth pursuing.\u00a0 But remember, the IRR only makes sense if the income and expenses on the proforma are reasonable and accurate.<\/p>\n<\/div>\n<\/div>\n<\/div>\n

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In addition, it\u2019s only one data point in the investment evaluation process.\u00a0 It shouldn\u2019t be used in isolation.<\/p>\n

Conclusion<\/strong><\/h3>\n<\/div>\n<\/div>\n
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When evaluating investment returns, IRR is a key metric that can be used to measure the success of an investment.\u00a0 It\u2019s useful in a variety of different scenarios, but has limitations. For this reason and others, it shouldn\u2019t be used to evaluate an investment in isolation.\u00a0 It should be used as a part of a suite of metrics that tell the entire story of the opportunity.<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n
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Glossary of Key Terms<\/strong><\/h4>\n

Internal Rate of Return (IRR)<\/b>:\u00a0 The rate of return earned on each dollar, for each period of time that it\u2019s invested in. It\u2019s calculated as the rate that sets the Net Present Value of an investment\u2019s cash flows (positive or negative) equal to zero.<\/p>\n

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Net Present Value (NPV)<\/b>:\u00a0 The present value of a series of cash flows is the current value of a future stream of income given an expected rate of return. Thus, the Net Present Value is the difference between the present value of future cash inflows and future cash outflows.<\/p>\n

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Holding Period<\/b>:\u00a0 An investor\u2019s holding period is defined as the amount of time for which they plan to hold an investment. It\u2019s usually expressed in either months or years.<\/p>\n

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Time Value of Money<\/b>:\u00a0 A financial concept which dictates that a dollar available today is worth more than a dollar available in the future, due to its ability to earn interest. It\u2019s the fundamental concept behind IRR.<\/p>\n

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Cost of Capital<\/b>:\u00a0 For a multifamily syndicator or lead partner, the cost of capital describes the total blended rate required to acquire funds for the project.\u00a0 If only debt is used, it may be equivalent to the interest rate on the debt. However, if some combination of debt and equity is used, it would be the blended cost of both.<\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n","protected":false},"excerpt":{"rendered":"

Measure Your Returns : Understanding IRR in Private Equity Real Estate Investments Note: Real Estate and Private Equity are specialized subjects that contain technical terms. To assist in the understanding of the subject matter contained in this Blog, we\u2019ve provided a glossary of key terms (in bold) at the end. When considering an investment in […]<\/p>\n","protected":false},"author":1,"featured_media":130,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[6],"tags":[9,17,13,18,19],"class_list":["post-126","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-educational","tag-33-holdings","tag-internal-rate-of-return","tag-irr","tag-private-equity","tag-real-estate"],"_links":{"self":[{"href":"https:\/\/33holdings.com\/learning-center\/wp-json\/wp\/v2\/posts\/126","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/33holdings.com\/learning-center\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/33holdings.com\/learning-center\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/33holdings.com\/learning-center\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/33holdings.com\/learning-center\/wp-json\/wp\/v2\/comments?post=126"}],"version-history":[{"count":2,"href":"https:\/\/33holdings.com\/learning-center\/wp-json\/wp\/v2\/posts\/126\/revisions"}],"predecessor-version":[{"id":129,"href":"https:\/\/33holdings.com\/learning-center\/wp-json\/wp\/v2\/posts\/126\/revisions\/129"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/33holdings.com\/learning-center\/wp-json\/wp\/v2\/media\/130"}],"wp:attachment":[{"href":"https:\/\/33holdings.com\/learning-center\/wp-json\/wp\/v2\/media?parent=126"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/33holdings.com\/learning-center\/wp-json\/wp\/v2\/categories?post=126"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/33holdings.com\/learning-center\/wp-json\/wp\/v2\/tags?post=126"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}