Simple Definition of IRR
As real estate has become more institutionalized, we have seen the proliferation of sophisticated investment metrics mentioned in every day discussions. From my understanding and experience speaking with older folks in real estate, those who became wealthy from RE in 80s and 90s did so because it was an inefficient and esoteric industry. Also, tech and info was not as ubiquitious. Now, probably the most popular/cliche metric is IRR. I have googled the definition of this term countless times and I know how to calculate it in my models but honestly, I can not explain what IRR is in simple layman’s terms.
How would you describe IRR?
This gives a good explanation of IRR but from a technical/behind the scenes POV, the chart almost half way down has always been my favorite deconstructed explanation of IRR
https://www.arborcrowd. com/education/why-irr-matters-evaluating-real-estate-investment-returns/
the discount rate that would make the NPV of a series of numbers equal 0
Without being too numerical, I like to describe IRR as an efficiency metric. The higher your IRR, the more efficient you are being with your equity.
This is where it’s important to view with EM. If your IRR is phenomenal, but as your hold period increases, the EM doesn’t increase much, and your IRR decreases (b/c it’s time weighted), this deal should be viewed as a short term play (a heavy value add with only bridge debt may show this). Opposite scenario, as your time frame increases, and your IRR is changing minimally, but your EM is going up fairly strong, you’re probably looking at a solid cash flow machine.
Sometimes you may not go with the highest IRR option, because it may mean more risk- but it’s important to know that in theory, you’re not being AS efficient with your capital in that deal as possible.
Outside of the obvious answer (discount rate that makes NPV 0 blah), it’s important to think of IRR in the context of growth rates.
IRR (no dividends/interim CF) = CAGR.
Think of it in the context of the S&P which has historically returned a CAGR of 8-9%, underwriting a rent CAGR of 4%, etc.
This is the best answer in this thread. Without lumpy cash flows, it’s basically just annualized growth rate/annualized returns. Timing and different cash flows can change it. There are some fun IRR calculators online that you can play with online to help build more of an intuitive sense.
It’s one of those things that’s overcomplicated by people in the industry all the time for some reason.
The discount rate that reconciles the price.
"annualized return"
This is the best answer, everyone seems to be going too in depth. To answer your question it is literally looked at as a return by an investor and compared with other investments such as stocks or bonds that a HNWI could invest in. These investors may look at real estate and say the stock market (S&P) is returning 10% on average this year, they're going to say I don't want a 10% return from real estate, since it has all this additional risk to make money I want a minimum 15% return to invest in a certain value add project or 25% return to invest in a ground up deal.
I don't have a ton of experience with waterfalls and overall LP returns, but this I believe is a good general thought process. IRR shows investors the return of an investment and that is likely compared to other investment opportunities with the risks analyzed. Time, etc affect IRR and the developer can play with that to make it look more appealing to an LP investor, but that's where the LP needs to know what they are looking at, typical structures, and if what the developer is offering is a good deal. GPs will always want to have a lower overall CoC and some will screw over LPs who are their friends who don't know any better to do that.
Just to be clear, when instituional investors compare returns (RE vs RE benchmark or SP500) for their allocation, they're using time-weighted returns (TWR). TWR takes out the timing of capital deployment and gives a more apple-to-apple comparison of all investment products. Can get financ-y real fast if you dig into it.
But yes, IRR = annualized returns in plain vanilla.
Effective compounded interest rate on an investment – so, if you invest $1,000 today, end up with $2,000 in 5 years, and contribute and earn nothing in between, the IRR is the interest rate you’d have to earn on that $1,000, compounded each year, to reach $2,000 in 5 years.
For high level conversation with the layman like you reference, it’s a return metric that smooths out lumpy cash flows over a period of time. Some real estate investments are not profitable until the end (sale / exit) and IRR paints a more holistic picture of how the deal performed versus a snapshot in time. If you took an early snapshot, pre stabilization, would look very different than IRR capturing the entire hold duration. Another general nuance is that IRR is used more for shorter term investments where you’re recycling capital and want to get it out of your hands as quickly as possible. Efficiency. Longer term holds maybe because it’s an oz deal or a family office that wants generational cash flow also focus on equity multiple.
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