Updated: Sep 8, 2020
How to evaluate a real estate deal? With so many metrics out there, it is easy to get confused as these metrics are often mixed together which makes it hard for investors to fully understand what the ROI might be. However, one of the first questions most people have is "What is the IRR?"
So many investors have been conditioned to focus on a large IRR number that they tend to forget about other important investment metrics. Is the IRR really as important as you think?
Here is what you should know about IRR when evaluating real estate deals.
What Is IRR?
The first thing that we should clarify is what IRR actually is. An IRR is a combination of all of the cash flows that occur during the life cycle of an investment. Sum up these cash flows and divide the cash flow by the number of years that you have held the investment in order to obtain your average IRR percentage.
Understanding Cash Flow Buckets
The first cash flow bucket is cash flow. After you receive the rent and pay any operating expenses and debt services, the remainder is your net cash flow. When you distribute this cash flow, the distribution is the cash-on-cash return. When calculating the IRR, the cash-on-cash return is one of the most important (and first) metrics you should look at as this money will be received throughout the life of the investment.
The second cash flow bucket is the principal reduction of the debt that is tied to the property. Cash flow from this cash flow bucket will depend largely on which debt service product you use. For example, it could be small if you an interest-only loan.
The third cash flow bucket is the capital gains that is received upon the sale of the property.
What the IRR Is Not
On the other hand the IRR is not a cap rate, cash-on-cash return, nor the return on investment. Surprisingly, people regularly confuse these other terms with the IRR. Here are the definitions of each of these terms:
Cap rate is a means of evaluating a property's market risk factors and performance
Cash-on-cash return refers to the calculation of the cash income earned on the cash invested in a property.
Return on investment (ROI) is a means by which the increase or decrease in an investment is made over time (preferably a short period).
As an investor, you must understand the difference between these terms.
Now that you see what goes into the calculation of the IRR and the secrets behind it, you now know to never accept an IRR percentage at face value.
Truthfully, IRR calculations are the most accurate when you look at them in hindsight. It’s easy to calculate your returns after the deal is done. But you are mostly going on assumptions at the time of the initial investment. That is why if you base an investment decision solely on IRR, you could end up in trouble when the assumptions you made don’t come to fruition.
What to Do Instead
While IRR is important, it should never be considered above all of the other important metrics. Some things you should consider are:
The future cap rate
The future cash flow
Mortgage rates if you want to refinance the property after year 3
Most importantly, make sure that the cash flow buckets are in line with your risk tolerance and priorities. Be on guard if the IRR seems to be an outlier as this might be an indication of a high risk deal.