What is IRR? How to Evaluate Multifamily Offerings
When browsing multifamily offerings, you’ll often see “projected IRR” touted as a selling point for the offer.
But what does IRR mean? Should the projected IRR be the deciding factor between investing with one firm versus another? Or are there other factors that you should consider as well?
In this guide, you’ll learn what IRR is, how to evaluate it, and how it compares to other real estate performance metrics.
What is IRR
IRR is a financial metric that measures the annual rate of return on an investment. IRR is used to evaluate the profitability of potential investments. It is calculated as the discount rate that brings the net present value (NPV) of all cash flows to zero. IRR is commonly used in capital budgeting to compare the attractiveness of different projects or investments.
How to Calculate IRR (Simplified Version)
To calculate IRR, you can use the following simplified formula (the true IRR formula is more complex, but this will provide a good approximation for most investors):
To calculate the IRR, follow these steps:
- Divide the Future Value by the Present Value
- Raise to the inverse power of the Number of Periods (i.e. 1 ÷ n)
- From the resulting figure, subtract by one to calculate the IRR
Here’s a practical example. Let’s assume that the present value is 3,000,000 and the future value is 5,000,000 on sale with a term of 5 years. Following the steps above:
- 5,000,000 / 3,000,000 = 1.667
- Take that to the power of ⅕, which equals 1.1076
- Subtract 1
And you end up with .107, or 10.7%.
What does this mean? In simple terms, IRR tells you the expected annual return on your investment, considering the timing and size of cash inflows and outflows. You can check out our IRR Calculator for an interactive example of projected returns based on IRR figures.
The Limitations of IRR
While IRR is a valuable metric for projecting returns and evaluating real estate deals, it is not perfect. There are a few limitations of IRR that you should be aware of:
- IRR assumes that all cash flows can be reinvested at the same rate as the IRR itself, which may not always be realistic in practice.
- IRR doesn’t account for the absolute size of the investment. A small project with a high IRR might be less profitable in absolute terms than a larger project with a lower IRR.
- Small changes in the timing of cash flows can significantly affect the IRR, potentially leading to misleading comparisons.
- IRR focuses solely on the project’s cash flows and doesn’t consider external factors like market conditions or the investor’s cost of capital.
IRR is a critical metric for evaluating multifamily real estate opportunities, but bear these in mind and utilize other metrics when comparing deals (we cover these metrics later).
What is a Good IRR?
You’ll see a wide range of IRR figures; a high percentage return (greater than 10%) indicates a successful investment, while a low IRR (less than 5%) might mean investors should reconsider their investment options. While there’s no one-size-fits-all answer, a good IRR for multifamily real estate investments typically ranges from 15% to 20% or higher.
It’s essential to consider factors such as the location, asset class, and risk profile of the investment. Check out our guide to analyzing a multifamily investment, and our guide to evaluating a multifamily firm for more information. In general, higher-risk investments should command higher IRRs to compensate for the additional risk.
How IRR is Used in Multifamily Real Estate Deals
IRR is a key metric that firms and investors alike use to understand the returns from a multifamily investment.
IRR allows you to assess the potential profitability of a deal and determine whether it aligns with your investment goals and risk tolerance. Sponsors and syndicators often use IRR projections to attract investors and demonstrate the expected returns of a particular deal.
How IRR Compares to Other Metrics
IRR is often listed with the following metrics when presenting the potential of a multifamily investment:
- ROI
- Cash on Cash return
- Equity Multiple
Let’s compare each of these side-by-side next.
IRR vs ROI
While IRR and Return on Investment (ROI) both measure the profitability of an investment, there are key differences to be aware of.
ROI is a simple metric that calculates the total return on an investment as a percentage of the initial investment. Unlike IRR, ROI does not consider the time value of money or the timing of cash flows. As a result, IRR provides a more comprehensive and accurate picture of an investment’s performance over time.
IRR vs Equity Multiple
Equity multiple is another metric used in real estate investing that measures the total return on an investment relative to the initial equity invested.
Equity multiple is calculated by dividing the total cash distributions plus the final sale proceeds by the initial equity investment. While Equity multiple provides a clear picture of the total return, it doesn’t account for the time value of money like IRR does.
IRR vs Cash on Cash Return
Cash on Cash return is a metric that measures the annual return on an investment based on the cash income earned relative to the cash invested.
Cash on cash return is calculated by dividing the annual pre-tax cash flow by the total cash invested. While cash on cash return is useful for assessing an investment’s short-term performance, IRR provides a more comprehensive view of the investment’s overall profitability, considering the time value of money and the entire holding period.
New to Multifamily Real Estate? Download our Investor’s Guide
IRR is a critical metric for real estate investors to understand and utilize in their investment decisions. By understanding IRR, you will be able to better compare and evaluate the potential of multifamily investments.
There’s much more to multifamily investing than this though, so we encourage you to download our free multifamily investing guide. In this guide you’ll learn:
- The tax benefits of investing in multifamily real estate
- Your options for investing in multifamily real estate
- How to evaluate firms
And more. Fill out the form below to download your guide.