Investing in commercial real estate (CRE) requires a comprehensive understanding of all factors that impact a potential investment. With all the metrics and acronyms to consider, it’s easy to get confused. The Internal Rate of Return (IRR) is one such metric. It is complex and often misinterpreted, even by financially savvy investors.
IRR is a financial metric that investors use when performing an investment analysis for commercial real estate (CRE). It measures the discount rate when an investment breaks even before making a profit. IRR differs from return on investment (ROI) as it factors in net present values (NPVs) over time.
Investors typically use IRR when comparing the feasibility of potential investments. It’s like a rubric that assesses assets on a level playing field. The rate is expressed as a percentage, offering investors a simple number (the result of a complex calculation). With an array of comparable percentages, investors can ascertain which CRE projects are worthwhile investments.
Understanding IRR in Commercial Real Estate: What is it?
Simply put, IRR is a discount rate that makes the total money you receive from an investment at a given point equal to the total cash inflow at the start of the project. It’s not a tangible metric because it requires guesswork and iterations to get the difference in NPVs as close to zero as possible.
IRR is based on the premise that the value of money changes over time, i.e., its value typically decreases due to inflation and other factors. Effectively, it acknowledges that you can do more with a dollar today than in the future, including reinvesting it for better returns.
To calculate IRR in commercial real estate, you need a comprehensive understanding of factors and risks that impact the market. However, as helpful as this metric is, investors should use it with other metrics, like equity multiples and cash-on-cash returns.
Components of IRR Calculation in CRE
Unlike ROI, which considers net profit relative to investment cost, IRR considers more components in its calculation. For instance, IRR factors in all cash flows (e.g., revenues, expenses, and any monetary gains or losses associated with the investment) and the timing of these cash flows.
Initial Investment
The initial capital infusion into a commercial property constitutes a critical component of IRR calculations. These include the purchase price, legal fees, renovation expenses, certificates, and all other upfront expenses associated with purchasing the property.
Cash Flows
IRR calculations in CRE hinge on estimating cash flows over the investment horizon. These cash flows comprise rental income, financing costs, operating expenses, and the eventual proceeds from the property sale. Precise forecasting of these elements is imperative for a reliable IRR calculation.
Hold Period
The holding period of an investment refers to the duration that the investor holds an investment before divesting it, i.e., from the acquisition to the sale of a security. It provides essential time data to more effectively measure the IRR of a project. Holds can be classified as standard or value-added, where the latter involves refinancing the project at a point.
Exit Strategy
An investor’s exit strategy involves how and when they plan to monetize the CRE investment, e.g., refinancing or selling the property. Exit strategy plays a pivotal role in cash flows, affecting the IRR calculation accordingly. A comprehensive analysis and comparison of IRRs for a project helps investors determine the most profitable time to implement their exit strategy.
Why is IRR an Important Metric in Commercial Real Estate?
IRR is an essential metric in CRE as it functions as a profitability gauge and comparison tool. It helps investors determine if the expected returns from a commercial property are worth the money invested in it and make informed decisions. IRR also significantly affects real estate pricing, given the tremendous scale and knock-on effects of investments in the field.
IRR Allows You to Compare and Rank Investment Opportunities
IRR provides a standardized metric to compare different investment opportunities. Investors use it to assess and rank potential CRE projects, facilitating a data-driven decision-making process.
It Helps with Risk Assessment
A higher IRR often implies a more lucrative investment but can also signify higher risk. Investors need to evaluate IRR with other metrics and consider the risks comprehensively.
An excellent way to assess risks is with a sensitivity analysis. This helps to assess risks in different scenarios, e.g., optimistic, pessimistic, and bare cases, which offer multifaceted perspectives when comparing IRRs.
IRR Helps with Decision-Making
Investors employ IRR as a vital tool when making decisions. By comparing the IRR and rate of return on a project, investors can make informed choices about whether to proceed with a particular CRE project or explore other investment opportunities.
What is a Good IRR for Commercial Real Estate?
A positive IRR implies an investment is likely to be profitable. On average, a good IRR for commercial real estate is between 7% and 20%. The higher the IRR, the more lucrative the investment. However, very high IRRs suggest higher risks. Hence, analyzing them as extensively as possible before committing to an investment is essential.
How to Calculate IRR
If math isn’t your forte, the IRR formula can be complex. The formula and its variables are explained in the table below:
| Internal Rate of Return (IRR) Formula | |
| 0 = NPV Σ CF n ÷ (1 + IRR)^ n | |
| Variable Symbol | Variable Description |
| NPV | net present value |
| N | hold period |
| n | each period |
| CF1, CF2, CF3, …, CFn | cash flows |
| CF0 | initial investment/ outlay |
| IRR | internal rate of return |
The calculation requires a lot of guesswork and iterations to get the IRR value as close to zero as possible. If you’re uncomfortable crunching numbers manually, use a financial calculator or specialized software instead.
Microsoft Excel includes the IRR and XIRR functions that do the iterations for you, provided you have all the cash flows and terms. This short tutorial shows you how to calculate IRR in Excel using both functions.
Challenges in IRR Calculation
Aside from the manual calculation errors, the other challenges when calculating IRR include the following:
- Proper cash flow estimation: Calculating future cash flow and NPVs requires a degree of guesswork. Over- or underestimating these figures can significantly impact the calculated IRR and lead to misguided investment decisions.
- Appropriate discount rate selection: The discount rate is pivotal in IRR calculations and should align with the investment’s risk profile. When discount rates are mismatched, they can distort IRR figures and lead to erroneous conclusions about the investment’s viability.
- Market volatility and other risks: real estate markets are particularly susceptible to economic, political, and social fluctuations. Given their profound effect on cash flows and IRR calculations, investors should factor in these variables when calculating IRR.
Conclusion
Understanding the nuances of the Internal Rate of Return (IRR) is indispensable for investors in commercial real estate. Investors who grasp IRR and its intricacies can use this valuable metric to make informed decisions, provided their information and estimates are as accurate as possible. Using IRR with other metrics is best to get a more realistic idea of a project’s viability.