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IRR is the discount rate where your Net Present Value is equal to zero over the entire course of your investment hold period. In layman's terms, it is the average annualized return of a deal, accounting for time value of money (i.e. if your IRR is 20% over 5 years and you put in $100 on day 1, you could get to your total cash proceeds at the end of your investment by multiplying $100 * 1.20 = 120 for year 1, $120 * 1.2 = 144 for year 2, and so on).

Cash-on-cash represents the net cash flow received from the property relative to the money put into the deal in a given year. So if you put in $1M and the property spits out $100k net in a year, you have a 10% cash-on-cash for that year. It doesn't examine the overall investment and is more concerned with yield at a point in time.

It's important to consider both because which matters to you depends on your investment goals. I can get a 20% IRR on a deal in different ways - either through steady annual cash flow, or by getting $0 during my holding period but selling at a huge profit at the end of the deal. So if my goal is to get steady cash flow from an investment, I care more about my cash-on-cash because that tells me what I should be getting out every year.

 

CREnadian

IRR is the discount rate where your Net Present Value is equal to zero over the entire course of your investment hold period. In layman's terms, it is the average annualized return of a deal, accounting for time value of money (i.e. if your IRR is 20% over 5 years and you put in $100 on day 1, you could get to your total cash proceeds at the end of your investment by multiplying $100 * 1.20 = 120 for year 1, $120 * 1.2 = 144 for year 2, and so on).

Cash-on-cash represents the net cash flow received from the property relative to the money put into the deal in a given year. So if you put in $1M and the property spits out $100k net in a year, you have a 10% cash-on-cash for that year. It doesn't examine the overall investment and is more concerned with yield at a point in time.

It's important to consider both because which matters to you depends on your investment goals. I can get a 20% IRR on a deal in different ways - either through steady annual cash flow, or by getting $0 during my holding period but selling at a huge profit at the end of the deal. So if my goal is to get steady cash flow from an investment, I care more about my cash-on-cash because that tells me what I should be getting out every year.

That’s not true regarding your IRR assumption, it’s really not even close to being a placeholder for average annualized return.

 

baboo.fei

image-20220620103510-1 See above for illustration of discussion in other comment chain.

Not really sure what you’re trying to show with this table. It doesn’t relate to any other comment chain, and actually also proves that the first comment I quoted was wrong as IRR clearly doesn’t tie to approximately CAGR in any sense unless you have zero interim cash flows.

 

I think we are agreeing here. IRR concerns the present / future value of a series of cash flows.

In the two series I show, the net present / future value of both series discounted by the IRR is (by definition) 0. The sum of future values (which is NOT the simple sum of all cash flows, think this is where people get confused) of all positive cash flows, wherever they occur in the series, is the same.

Think people need a refresher on PV/FV sometimes…

 
baboo.fei

image-20220620103510-1 See above for illustration of discussion in other comment chain.

Having a very hard time understanding what the confusion here is for everyone, as I've laid it out a very straightforward refutation that shows that IRR is simply not the average annualized return of an investment, as the original user posted.  Again, it was claimed that IRR was "In layman's terms, it is the average annualized return of a deal, accounting for time value of money (i.e. if your IRR is 20% over 5 years and you put in $100 on day 1, you could get to your total cash proceeds at the end of your investment by multiplying $100 * 1.20 = 120 for year 1, $120 * 1.2 = 144 for year 2, and so on).  This isn't true.  In absolute no case can you conceptualize IRR as being anywhere close to an average annualized return, nor does that example that was posted even make sense.

 

And is average annualized return the same as CAGR?

Edit: read the above comments and yes, CAGR can be interpreted as average annualized return.

 

@steam do you work in CRE? Your description of IRR seems more in line with a definition out of a Bonds textbook. I don't think that many CRE professionals view IRR primarily as a proxy for how quickly you will get paid back. Don't think you're wrong… holding your equity multiple constant, a deal with a higher IRR will generally have a shorter hold period (haven't done the math but that logic seems right)…. But real estate investors typically underwrite a particular hold period, so we already have a view on timing. Semantics aside - It's a much more relevant metric to compare the time adjusted,  total/ "annualized" return between different investments that have different cash flows and timing. Investors underwrite business plans and timing; IRR is a far less useful metric to explain that.

 

Levered2Gills

@steam do you work in CRE? Your description of IRR seems more in line with a definition out of a Bonds textbook. I don't think that many CRE professionals view IRR primarily as a proxy for how quickly you will get paid back. Don't think you're wrong… holding your equity multiple constant, a deal with a higher IRR will generally have a shorter hold period (haven't done the math but that logic seems right)…. But real estate investors typically underwrite a particular hold period, so we already have a view on timing. Semantics aside - It's a much more relevant metric to compare the time adjusted,  total/ "annualized" return between different investments that have different cash flows and timing. Investors underwrite business plans and timing; IRR is a far less useful metric to explain that.

Yes, with a stint in banking, and 2 years in infrastructure PE in between.

IRR is a proxy for comparing two investments on which will yield faster cash flow back to investor.

The gripe I’m raising is with the way many people visualize and explain IRR; in that it is “average annualized compounded return”. In no way, shape, or form is that even approximately true, as I’ve laid out. Nobody here has - at all - proven that incorrect with an actual example. Everyone here as - by and far - either moved goal posts or drastically misunderstood what I’ve brought up.

I mean, seriously, my issue has not changed a bit since my first post. I’ve already fielded defense against multiple posts included ‘your second example shows a 39% CAGR’ which I’ve specifically explained was manually done to prove my point. It’s like I’m talking to people who have never opened a finance 101 textbook.

If you don’t understand what IRR is, that’s fine, but don’t chime in and try to act like it’s correct to conflate IRR with CAGR (one poster said they are literally the exact same, despite actual shown examples showing otherwise).

The fact still, and always will, stand that you cannot visualize IRR as an annual compounded return. It doesn’t yield the same return, they are not the same metric, and IRR is only used to compare two relative investments OR to show net annual return on capital outlayed.

This really isn’t a hard concept to grasp, and I’m shocked any of you actually work in finance if you’re struggling this hard to follow my point - which is loosely but primarily based off of Oaktrees newsletter ‘You can’t eat IRR’ which clearly nobody here has read.

 

IRR is a proxy for comparing two investments on which will yield faster cash flow back to investor.

tbh..... I'm at somewhat of loss for words on the above statement. The vast majority of real estate deals have the investors getting relatively small annual dividend/distributions with a large terminal value payoff from recapitalization (sale and/or refinancing) that comparing "time" isn't really a common discussion (I mean, sure its a factor). Ironically, the "shorter" duration deals (like development or intense value-add) have the highest target total returns and the "longest" like 10 year+ to perpetual life have the lowest (like core funds). So, in real estate, investors tend to accept lower target total returns (IRRs) for longer duration deals (lower risk in all). But again, holding period tends to arbitrary for stabilized deals so not really major deal factor. In development, the more profitable deals often (or usually I'd guess) take longer, and give higher IRRs.... but the risk trade off is more from risk nature (like larger in scale/complexity or need to secure entitlements, etc.) than the time dimension. 

In sum, shortening a holding period rarely gives much benefit in real estate, just practical reality. 

Finally.... on this notion that IRR is wildly different than CAGR.... let me just quote Investopedia for simplicity (not trying to insult you Steam, but I can't let this stand, and I think maybe you are mixing the concepts of "holding period returns" with "multi-period returns", which would make all your statements far more logical...).

Understanding IRR

The ultimate goal of IRR is to identify the rate of discount, which makes the present value of the sum of annual nominal cash inflows equal to the initial net cash outlay for the investment. Several methods can be used when seeking to identify an expected return, but IRR is often ideal for analyzing the potential return of a new project that a company is considering undertaking.

Think of IRR as the rate of growth that an investment is expected to generate annually. Thus, it can be most similar to a compound annual growth rate (CAGR). In reality, an investment will usually not have the same rate of return each year. Usually, the actual rate of return that a given investment ends up generating will differ from its estimated IRR.

IRR vs. Compound Annual Growth Rate

The CAGR measures the annual return on an investment over a period of time. The IRR is also an annual rate of return. However, the CAGR typically uses only a beginning and ending value to provide an estimated annual rate of return.

IRR differs in that it involves multiple periodic cash flows—reflecting that cash inflows and outflows often constantly occur when it comes to investments. Another distinction is that CAGR is simple enough that it can be calculated easily.

 

Levered2Gills

@steam do you work in CRE? Your description of IRR seems more in line with a definition out of a Bonds textbook. I don't think that many CRE professionals view IRR primarily as a proxy for how quickly you will get paid back. Don't think you're wrong… holding your equity multiple constant, a deal with a higher IRR will generally have a shorter hold period (haven't done the math but that logic seems right)…. But real estate investors typically underwrite a particular hold period, so we already have a view on timing. Semantics aside - It's a much more relevant metric to compare the time adjusted,  total/ "annualized" return between different investments that have different cash flows and timing. Investors underwrite business plans and timing; IRR is a far less useful metric to explain that.

After all, what good is using an incorrect layman’s definition of a concept if you can’t probably show by example how it makes sense to view it that way?

Everyone here wants to claim IRR for whatever reason equates to annual compounded return but zero people - none - can come up with an actual example (with interim cash flows, aka 99% of investments) works under that definition?

This is BANANAS. B-A-N-A-N BANANAS.

 

Are you meaning to compare holding period returns (like ROI) with multi-period returns (IRR)? See this from Investopedia again, is that what you are trying to say?

Return on Investment vs. Internal Rate of Return: What's the Difference?

By 

CAROLINE BANTON

 

Updated February 07, 2022

Reviewed by 

ERIC ESTEVEZ

Fact checked by 

PETE RATHBURN

Return on Investment (ROI) vs. Internal Rate of Return (IRR): An Overview

While there are many ways to measure investment performance, few metrics are more popular and meaningful than return on investment (ROI) and internal rate of return (IRR). Across all types of investments, ROI is more common than IRR, largely because IRR is more confusing and difficult to calculate.1

Companies use both metrics when budgeting for capital, and the decision on whether to undertake a new project often comes down to the projected ROI or IRR.2 Software makes calculating IRR much easier, so deciding which metric to use boils down to which additional costs need to be considered.

Another important difference between IRR and ROI is that ROI indicates total growth, start to finish, of the investment. IRR identifies the annual growth rate. The two numbers should normally be the same over the course of one year (with some exceptions), but they will not be the same for longer periods.

 

OP... this thread was totally highjacked lol.... you asked about Cash on Cash return and IRR... (not CAGR or whatever it devolved into lol)., so let me answer your question simply..

Cash on Cash Return (aka Equity Dividend Rate) - is a measurement of "Income Return", and is pretty simple to calculate (Total Cash Received/Total Cash Invested), and is equally simple to interpret (like how much 'income' will your investment generate not factoring selling or change in valuation). A lot of private investors use this as their main investment analytic. IRR and NPV by comparison are total return metrics, thus they require a 'terminal valuation' (meaning a sell assumption) which puts a lot more 'assumptions/guesses' into the metric, but it also is irrelevant to an investor with little desire/intention to sell. Real estate assets are very often traded on their ability to generate 'income' and cash on cash return is a direct measurement of that. 

IRR, by contrast, is a 'total return' measurement and factors all cash flows... dividends, returns of capital/refinances, proceeds from sale etc. based on their timing. It is a 'time value of money' accurate measurement and thus is useful in comparing various investments over time. To calculate, you must make sale/valuation assumptions, thus, it is subject to more 'guesswork' (including a holding period, like number of years, assumption as well as income growth assumptions and exit cap rate assumptions). Still, IRR gives an estimate or calculation of the total investor 'experience' as where cash on cash is just one component. 

Other final point on cash on cash, it is "usually" compared on a first year or first 'stabilized' year basis (at least when comparing a prospective purchase), yet could be calculated/estimated for every year of a multi-year proforma. Still, many investors go off 'year one' for decision making (clearly, this is no rule, just old school practice, any one can do as they please).

Does that all make sense?

 

That was entertaining. In my opinion, and the general consensus as far as I know, is IRR absolutely is, in layman terms, your annualized annual return. Most investors are sophisticated enough to understand that's inclusive of both appreciation and current cash flow. So if cash on cash is 10%, but IRR is 15%, most people understand the 5% above the cash on cash is due to the appreciation in value and potential ability to realize that via an exit.

Also, to throw out the worry of interim cash flows and look only at terminal value, look at each year as if it were it's own investment.

Example: $100k investment which earns $10k annually for 5 years with a sale of $200k at end of year 5. 

  0 1 2 3 4 5
Investment      (100,000)          
CFFO        10,000      10,000      10,000      10,000      10,000
CFFS              200,000
Net CF      (100,000)      10,000      10,000      10,000      10,000    210,000
             
IRR 23%          

Can be looked at as 6 different investments (5 years of CF and exit):

  Initial Investment Future Value Year Realized CAGR
CFFO - 1             8,148      10,000 1 23%
CFFO - 2             6,638      10,000 2 23%
CFFO - 3             5,409      10,000 3 23%
CFFO - 4             4,407      10,000 4 23%
CFFO - 5             3,590      10,000 5 23%
CFFS          71,808    200,000 5 23%
Total Investment        100,000      

If this was a portfolio of 6 different securities that you spread out $100k over today based on the initial investments above, and each one would be worth the indicated FV at the indicated number of years from now, you would determine this portfolio produced a 23% average annual return.

 

Steam you should probably comment on this above example (which was brilliantly done). My main contention was with the statements you made way up above:

Everyone here wants to claim IRR for whatever reason equates to annual compounded return but zero people - none - can come up with an actual example (with interim cash flows, aka 99% of investments) works under that definition?

This is BANANAS. B-A-N-A-N BANANAS.

and further up

The gripe I'm raising is with the way many people visualize and explain IRR; in that it is "average annualized compounded return". In no way, shape, or form is that even approximately true, as I've laid out.

Just pulling a few to highlight why myself and the above anon poster have taken issue (and let's just call a spade a spade.... totally disproven...). I guess you have recanted the above and revised this to be something about connecting initial investment to total profit at Y5/sale (paraphrasing). That would be changing the terms and facts of the payouts of the deal itself, hence, not a fair comparison (and yes, I think we agree on that last point to be fair). 

 

redever

Steam you should probably comment on this above example (which was brilliantly done). My main contention was with the statements you made way up above:

Everyone here wants to claim IRR for whatever reason equates to annual compounded return but zero people - none - can come up with an actual example (with interim cash flows, aka 99% of investments) works under that definition?

This is BANANAS. B-A-N-A-N BANANAS.

and further up

The gripe I'm raising is with the way many people visualize and explain IRR; in that it is "average annualized compounded return". In no way, shape, or form is that even approximately true, as I've laid out.

Just pulling a few to highlight why myself and the above anon poster have taken issue (and let's just call a spade a spade.... totally disproven...). I guess you have recanted the above and revised this to be something about connecting initial investment to total profit at Y5/sale (paraphrasing). That would be changing the terms and facts of the payouts of the deal itself, hence, not a fair comparison (and yes, I think we agree on that last point to be fair). 

Sure, it definitely is an accurate way to portray PV in simple terms, but it also answers a completely different question than what I was coming up with a solution for in the first place.  It's important to note that again - as I've continued to say this entire time - that doesn't mean the above reasoning is invalid, but it's not even the point of what I was trying to portray.  If you look at the specific line of questioning that I had raised issue with:

(i.e. if your IRR is 20% over 5 years and you put in $100 on day 1, you could get to your total cash proceeds at the end of your investment by multiplying $100 * 1.20 = 120 for year 1, $120 * 1.2 = 144 for year 2, and so on)

^ This is what I had a problem with, as I said this will simply confuse some people who may use it as valid reasoning to try to mentally back into a profit and be left empty handed.  So, my solution was to come up with a way that somehow links the original investment to your profit in a simple way that doesn't leave someone mentally doing gymnastics by an explanation.  My explanation takes into account an aggregate compounded yield (by way of factoring net dividends as a reduction of net capital outlayed) and the above explanation breaks the initial investment up into X number of investments that are held for various time periods and returned back at separate time frames.  Both are accurate, but the reason for my explanation in the first place was that I felt it was more straightforward and easier to explain..which it arguably is - all I'm asking you to do in my explanation is add 3 extra sentences that seem to cause this massive uproar with some people (you) despite it somehow being missed that both explanations are mathematically doing the same exact thing.

What I've been saying since the start is that my purpose was to find a way to jam a square peg in a round hole (e.g. explaining IRR in such a way that takes initial investment and spits out profit) if you want to do that via one aggregate investment from year 1 and link this to profit through your hold period, my explanation makes sense, whereas if you want to do this via hypothetically breaking up your deal into 5 separate transactions that return money at different time periods and don't get re-invested, then the alternate explanation makes sense (albeit, I'd argue ironically that this explanation is in fact "changing the terms and payouts of the actual deal" by the mere fact you're starting out with the term "hypothetically" and assuming it's #X of deals rather than one actual deal.

It's really your preference at the end of the day, but I do prefer using as close to actual deal dynamics as possible, rather than break off into hypotheticals personally.  Again, it's as if you think I'm somehow arguing that IRR =/= when NPV is 0.  Of course it does, but these explanations have nothing to do with what I was solving for - in the case of my initial question that was posed, even answering with "IRR is simply when NPV is 0!" is meaningless and not a solution / wrong in this case.  I don't know how this is that difficult to grasp.

 

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