IRR even cash flows
I had this Q in an interview:
Exit Cap rate = 5% purchase price = £100M Cash flow/year = £5M Horizon = 5 years
What is the IRR?
I calculated this using my calculator by finding the MOIC and then an approximation formulae to get the IRR.
However, interviewer wanted an intuitive method to get the answer. Could someone help? (Ans is approx. 5%)
I don’t work in real estate (the RE stands for renewable energy) but wouldn’t this intuitively mean 5%?
If you are divesting at a cap rate / discount rate of 5%, and your annual cash yield is 5%, then you are divesting to a buyer who has the same discount rate / cost of capital as you do. This means that, assuming the property produces this 5m of cash flows (pre inflation) in perpetuity, your IRR on the investment + exit is 5%.
To add onto this, it appears the purpose of this question was to test your conceptual understanding of “cost of capital”.
Thank you very much!
But if we apply this logic to a cap rate of 10% and an annual cash yield of 10% too that would imply an IRR of 10%.
However, the actual IRR of that is approx. 8.4%
Does this mean it only works with small numbers?
You aren't escalating the cashflows.
You're missing the point here. If the hold-to-maturity IRR is 10%, and you divest it to a buyer with a discount rate of 10%, then you're IRR to exit is 10%. He asked you this question to understand the impact of cost of capital on valuation ("NPV").
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