Here’s an interesting question I receive all the time: “How do I evaluate a real estate deal?”
There are so many different metrics out there like a cash-on-cash return, return on investment, capitalization rate, annualized rate of return, and internal rate of return. It’s easy to get confused, as these metrics are often blended, making it hard for the investor to understand what their actual returns will be.
Speaking from experience, the first question I most often receive when presenting a new offering on an apartment syndication is, “What’s the IRR?”
I rarely get a follow-up question regarding the IRR. It’s almost as if the investor has been conditioned to overlook other investment metrics in order just to focus on a large IRR number.
A dirty secret in the industry is that an IRR can be easily manipulated. I am going to show you some of the assumptions an operator can use to inflate the IRR. But for a more in-depth view of how IRRs can be manipulated, you have to check out Brian Burke’s recent BiggerPockets book The Hands-Off Investor: An Insiders Guide to Investing in Passive Real Estate Syndications. The book is a must-read for investors and new syndicators alike and is what inspired me to write this article.
Reading The Hands-Off Investor will help you ask the right questions. In fact, there are 72 questions to ask a potential sponsor included with the purchase of the book when you order it from BiggerPockets.
What IRR Is Not
Repeat after me: “IRR is not a cap rate, nor is it cash-on-cash return, nor is it a return on investment.”
Believe it or not, people confuse the terms all the time. Here’s a quick definition of each:
Cap rate is a way to evaluate a property’s performance and market risk factors.
Cash-on-cash return is a rate of return often used in real estate transactions that calculates the cash income earned on the cash invested in a property. It’s also an input into the IRR formula, which I’ll discuss more below.
Return on investment is a means to evaluate the increase or decrease in an investment made over a set time (preferably a shorter period).
While these terms may seem like gibberish, it’s important as an investor to know the difference between them.
What Is IRR?
An IRR is a culmination of all the cash flows throughout the life cycle of an investment. You sum up all those cash flows and divide the cash flow by the number of years you have held the investment to obtain your average IRR percentage.
3 Cash Flow Buckets
The first cash flow bucket is—you guessed it—cash flow. Typically, after you receive your rent and pay your operating expenses and debt service, what’s left over is your net cash flow. When you distribute that cash flow, the distribution is the cash-on-cash return. When calculating the IRR, the cash-on-cash return is the first (and maybe most important) metric to look at—this is the money you will be receiving throughout the life of the investment regardless if the property is sold or not.
The second cash flow bucket is the principal reduction of the debt tied to the property. For example, the initial mortgage had a $5,000,000 balance. But when the property is sold, the balance was only $4,000,000. So, a difference of $1,000,000 is your principal reduction.
It’s important to note that the cash flow received from this bucket largely depends on the debt service product used. This cash flow bucket may be small if an interest-only loan is used. However, in those situations, your cash-on-cash return is typically higher throughout the investment since you’re paying less in debt service during your interest-only period.
The third cash flow bucket is the capital gains received when selling the property. This is just the difference between what you bought the property for and what you sold the property for. To calculate the IRR percentage, you add up all three cash flow buckets and pay back your original investment. Then, you divide the remaining amount by the years the property is held for. This amount is your average IRR.
This is why IRR doesn’t kick in until your capital is returned. This is also why an early refinance can have a tremendous impact on an investment’s IRR.
Does IRR Even Matter?
Now that you know about the cash flow buckets, you can see why an investor should dig deeper into the IRR percentage and not just accept it at face value.
Just the other day, I received a marketing package on a new deal with only the following information:
What the deal was
What the IRR was
How to contact them
I was left scratching my head. How would an educated investor be able to decide if this investment might be right for them?
Imagine how disappointed an investor who relies on distributions would be if the project had little or no cash-on-cash return. That same investor would have been better off investing in a project with a lower annualized IRR but greater cash-on-cash return.
IRR’s importance will also depend on the type of investment you analyze. While IRR can be used to analyze almost any type of investment, IRR’s significance can become quickly diminished when analyzing a smaller, more active asset.
I sometimes get asked to help determine the IRR for a single-family rental or a small duplex. While it may be a good exercise to calculate, your investment decision will probably depend on other factors like location, property management, and financing. Compare this to a larger, more passive investment, where those variables are handled by the operator before you ever see the offering. This leaves the investor with fewer variables to worry about, increasing the importance of what the IRR will be.
Dirty Secrets of IRR
IRR calculations are most accurate in hindsight. It’s easy to calculate your actual returns after the fact. But during the time of the initial investment, you have to make assumptions.
Here are some things to consider:
What will the cap rate be in the future?
What will the cash flow be in the future?
What will the mortgage rates be like if you were to refinance the property year 3?
A sponsor needs to make assumptions on all these things. This is why it is so easy to manipulate IRR. A deal with poor cash-on-cash return can be easily offset with an aggressive cap rate projection because the profits on the backend will make up for it.
The only cash flow bucket we might know for sure is the principal reduction. But again, depending on a refinance, that may not be the case. When an operator talks about being conservative in their underwriting, they are usually referring to the assumptions they are making. However, one or two incorrect assumptions can quickly derail a deal. This is why if you only base your investment decision on just IRR, you can be in for a world of hurt when those assumptions don’t pan out.
The Bottom Line
IRR does matter. It just shouldn’t be placed on a pedestal above all other metrics. The truth is when presented a deal, an investor should take note of what the IRR is on the project. More importantly, he or she should make sure that the cash flow buckets are in line with what they prioritize and their risk tolerance.
Beware of an IRR outlier since this might be a warning that the deal’s risk level is high. As a famous Warren Buffet saying goes: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”
By reading The Hands-Off Investor: An Insiders Guide to Investing in Passive Real Estate Syndications by Brian Burke and understanding how your next deal’s IRR breakdown works, you can avoid losing money.