Why You Can’t Only Rely on IRR When Evaluating a Real Estate Investment

Internal rate of return (IRR) is an essential metric for real estate investors. It calculates an annualized rate of return while considering the time value of money (TVM). TVM states that a dollar today is worth more than a dollar at some point in the future. Taking all of these variables into account, IRR allows investors to compare investments with unsteady cash flows, variable payment schedules, and differing total equity.

Even though every real estate investor needs to know what IRR is and how it works, the metric does have its limitations.

In this article, we’ll discuss those limitations. IRR tends to overemphasize earlier distributions, ignoring overall profitability. Also, since you need to make predictions about future distributions, which opens up the possibility for error.

 

Problem #1: Two Investments Can Have the Same IRR with Extreme Differences in Profitability

IRR works by setting the net present value to zero. This is how it incorporates the time value of money. This way, you can find the discount rate that brings your future expected distributions to zero.

Put simply, this emphasis on TVM puts a lot of weight on earlier distributions and heavily discounts later distributions and final sales, even when those sales generate a lot of profit. Depending on your time horizon,

For example, let’s look at three possible investments.

The first looks like this:

  • Equity: $10,000
  • Year 1: $2,000
  • Year 2: $2,000
  • Year 3: $1,000
  • Year 4: $1,000
  • Year 5: $1,000
  • Return of equity at end of investment: $10,000

This gives you a whopping 14.84% IRR. All in all, you earned $7k on a $10k investment over the course of five years, a solid return.

What happens if we flip the payment structure so that you get the extra distributions on years 4 and 5?

  • Equity: $10,000
  • Year 1: $1,000
  • Year 2: $1,000
  • Year 3: $1,000
  • Year 4: $2,000
  • Year 5: $2,000
  • Return of equity at end of investment: $10,000

This brings the IRR down to 13.27%, more than a full percentage point. However, you still earned $7k on a $10k investment over the course of five years.

Finally, to really highlight this discrepancy, let’s look at a third investment. It doesn’t pay any distributions for two years, but you receive a chunk of the profits at the end of five years when it’s sold:

  • Equity: $10,000
  • Year 1: $0
  • Year 2: $0
  • Year 3: $2,500
  • Year 4: $2,500
  • Year 5: $2,500
  • Return of equity at end of investment: $10,000
  • Share of profits: $1,000

In this scenario, your IRR is 14.45%, still lower than the first investment. If you were only using IRR to compare the two, you might conclude that the first investment is better than this investment.

However, for the third investment, you earned $8.5k on a $10k investment. For the first investment, you earned $7k on a $10k investment.

That’s a difference of over $1.5k (15%) in profit, and yet the IRR for the first investment is still significantly better than it is for the second investment.

 

Problem #2: IRR Relies on Projections for Future Distributions

Secondly, the IRR relies upon estimates of future distributions. Those estimates are subject to a wide range of potential confounding factors that are outside of anyone’s control:

  • Bad weather can delay construction projects by weeks.
  • A shift in migration patterns could erode demand.
  • A pandemic could destabilize the wider economy.
  • Changing interest rates could cause property values to plummet.

Many beginner investors tend to fall in love with models, like the IRR, that make everything seem much more easily predictable than it really is, while more experienced investors know that projects almost never go according to plan. It’s always better to err on the side of safety so that you don’t overreach.

All in all that means the IRR is subject to optimism bias. People have a tendency to see the glass half full, underestimating time to completion and budgets.

 

Conclusion: Why You Can’t Only Rely on IRR When Evaluating a Real Estate Investment

IRR is not an all-encompassing metric. It should be one tool in a toolbox of other metrics and formulas you should use to determine the risk and profitability of your investments.

While IRR incorporates the time value of money, it tends to overemphasize earlier distributions and underemphasize later distributions and payouts. As we saw in our examples, this could lead to a 15% difference in total return, with the IRR staying roughly the same.

Finally, since you need to make estimates regarding future distributions, IRR is subject to optimism bias — and it doesn’t take into account a range of external factors.

 

 

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