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Investors frequently ask us what metric is the best to analyze and valuate a real estate opportunity. At Kenwood, we utilize multiple models to underwrite each acquisition. However, we find that, compared to other models, the Internal Rate of Return (IRR) captures more comprehensively the scope and characteristics of real estate investing, including its irregular cash flows, capital expenditures, and debt service. Because the IRR factors in the element of time, meaning the investment’s duration from property acquisition to disposition, it is unique compared to other models. Since it produces a result, expressed as a percentage, the IRR enables investors to more effectively understand the anticipated return and to easily compare it to alternative investments.

The Importance of Time

The fundamental concepts behind an IRR are its abilities to combine and measure both time and profits (or cash flows) into a single analysis. You may wonder why is this important? Here’s a simple explanation.

Investment Option #1

  Initial Investment Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Profits ($10,000) $0 $0 $0 $0 $0 $0 $0 $0 $0 $20,000
IRR 7%                    

Investment Option #2

  Initial Investment Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Profits ($10,000) $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $11,000
IRR 10%                    

In both examples, the initial investments are identical — $10,000; the total profits are each $10,000 and the final sale prices are the same ($10,000). In option #1, the investor must wait 10 years to experience any return. In option #2, the investor receives $1,000 every year for 10 years. Although the overall profits in both examples are the exact same, $10,000, the IRRs are quite different (10% vs. 7%). This results from introducing time into the analysis and demonstrating that inflation (even a small amount of it) makes money worth less the longer an investor must wait for it.

This ability to evaluate the impact of time on an investment’s overall return makes the IRR unique in its modeling capabilities. Other frequently used real estate evaluation metrics, such as cap rate, price per square foot, equity multiplier, or gross rent multiplier, don’t consider an investment’s duration in their analysis. Think about the importance of this. For example, an investment opportunity yields a cap rate of 8%. Recall that a cap rate is calculated by taking the Net Operating Income (NOI) and dividing it by the property’s value or purchase price. But it is solely based on only one year’s NOI — it doesn’t consider irregular cash flows. It also doesn’t account for the property’s future sale price and how long you need to hold the investment to achieve this outcome.

The Value of Looking Forward and Backward

Another unique feature of the IRR is that it can evaluate an investment’s forecasted cash flows as well as its past performance (historical cash flow distributions) and combine both results into one overall return percentage. This enables an investor to:

  1. reevaluate the investment on an ongoing basis.
  2. compare historical performance with forecasts to determine if the investment is projected to maintain, increase, or decrease its returns.
  3. evaluate different exit strategies over time. An investor can easily determine the optimal time to sell — in three years, five years, or longer.

Comparing Dissimilar Investments

Because of its easy-to-understand percentage results, an IRR can enable an investor to compare dissimilar investment opportunities. For example, with an IRR calculation, investors can compare projected returns of an office building to a publicly traded stock, and/or to raw land. If an IRR calculation were not utilized, it would be nearly impossible to effectively compare the potential returns across these varied opportunities.

IRR Shortcomings

Investors should be cautious of two shortcomings of the IRR. Like any model that produces projections of future returns, the model’s underlying assumptions about future events must be realistic; otherwise, the model’s ability to forecast becomes pointless. For example, in real estate models, certain assumptions are forecast about market rents, rent growth, inflation, renewal probability, free rent, tenant improvements, and terminal sales price. If reasonable assumptions aren’t projected or they are too optimistic, then the results will be overestimated. We always encourage an investor to investigate an investment model’s underlying assumptions.

Second, investors still need to apply their own “sniff test” to evaluate the risk/reward ratio. For example, if we were to compare two investment opportunities, one with an IRR of 10% and the other 14%, which one would you pursue? Many investors might be drawn to the higher return. However, if we added that the 14% investment was risker, how would that change your perspective?

Here’s a specific example. A well-located and leased real estate investment is projected to produce a 10% return. Another option to consider is a medical stock with a promising new drug that is projected to produce a 14% return. However, to achieve that return the drug must be at least 80% effective and needs to secure FDA approval. Does a 4% higher return, i.e., the reward, justify the risk associated with the medical stock’s needed achievements when compared to the stable real estate investment? This is where each investor needs to evaluate the risk/reward ratio to make their final investment decision.

The Value of “What-ifs” and Sensitivities

An IRR analysis also provides an opportunity to evaluate various what-if scenarios that many other metrics do not. An investor can easily determine if a projected capital improvement under consideration will enhance the investment’s overall return. For example, an investor is evaluating a retail center. The investor’s thesis is that the center could benefit from an improved facade and updated signage. After the work is completed, the investor believes that rents could be increased by 10%. Utilizing an IRR analysis, the investor can easily determine the return for making the capital investment and confirm if the planned improvements are justifiable.

The IRR calculation also enables an investor to easily adjust various modeling assumptions to determine their sensitivity to the overall result. For example, it is easy to evaluate the impact of market rents growing at 2% per year instead of 2.5% on the investment’s overall return. By performing sensitivities, an investor can determine which variables can have the greatest impact on the property’s performance.

The Value of Debt

Lastly, IRRs can also be utilized to determine if an investment benefits from leverage (debt). Debt would reduce an investor’s initial cash outlay. Correspondingly, it would decrease an investor’s annual cash distributions because of required debt service payments. However, if the cost of loan (i.e., interest rate) is low enough, debt can enhance the investor’s overall return.

Effective investment decisions require the ability to evaluate various metrics to produce the best results. The IRR is one effective model because it considers the impact of time. At Kenwood, we believe in diligently and carefully underwriting every asset we purchase.

Kenwood Management is always looking for new investors to join the Kenwood Community. Learn more about our investment services and how you can generate steady and secure commercial real estate gains with our team of experts.