Hey everyone. So I have been having trouble understanding the concept of IRR.
From my understand it is simply known as the discount rate that makes the NPV = 0. However, if the IRR is simply the discount rate, won't it mean that no matter what percentage IRR there is (20% IRR, or 5% IRR), the NPV will always be 0?
Doesn't this mean that theoretically in 10 years when you sell a property, you didn't really make any money if you account for NPV because the NPV=0?
No offense or anything, but I would suggest reading through the first few chapters of an intro to finance textbook, because this question shows a decent lack of understanding of the concept of an NPV.
The discount rate is what you want. The IRR is what you get. The NPV quantifies the difference.
Nice, but I would say that the discount rate is what you expect, not really 'what you want.'
Your discount rate is what you want to achieve. Discount rate is entirely subjective and differs from investor to investor.
Example: I have a pile of money from 10 investors who want me to invest in NYC hotels. Collectively, I know they want at least 7% IRR on each deal they invest in. That's my discount rate that I apply to every transaction I analyze.
Rchan100,
I am assuming you are a student, and you have come to a good place for advice. NPV of 0 is usually expected in all transactions... NPV is the present value of future financial benefit net of your purchase price for the asset. Of course you make money if the NPV is zero, this is expected because positive NPV means you are receiving excess return. A positive NPV just means you are realizing a return that is even better than what you require based on your cost of capital (you're expected return).
If you are underwriting a deal to positive NPV, this means that the seller would be giving you a great deal. Do not expect this to happen because this is America after all. NPV (Buyer) = NPV (Seller) = 0
The IRR is not the discount rate. Well, it is, but not in the sense you are talking about. You are correct in that it sets the NPV to 0. The discount rate in known as the WACC (weighted average cost of capital). This is the required return you must make in order to satisfy your equity and debt responsibilities and is the rate used to discount cash flow values to the present.
WACC = [(1-LTV) * (Cost of Equity)] + [(LTV) * (Loan Rate) * (1-Tc)] - Tc = Corporate tax rate since debt is tax deductible.
If the IRR > discount rate, the deal is favorable becuase you are able to meet your cost of equity and debt and then some.
Yes, they can and they do. But IRR is not an intellectually honest number when discussing rate of return. IRR is your rate of return assuming you re-invest periodic cash flows at the IRR. So, for a project that is throwing off a 20% IRR, it assumes you take your cash flows and re-invest at 20%. That's not a realistic assumption generally speaking.
Yes, OP this is what we do. I may have mislead you earlier. IRR is in fact the rate of return that you are describing, the WACC is just the rate that you use when discounting cash flows for NPV analysis. You want as high an IRR as you can achieve and to show you how this affects real estate investors, go look up equity waterfalls.
In a typical JV development deal, a development firm will provide a slice of the equity, and an LP partner will provide the rest. They will split the cash flows based on IRR hurdles; here is in example.
Equity Figures: GP - 2,000,000 (33%) LP - 4,000,000 (67%)
First, lets say the partners agree to split the cash flows "pari passu" (latin for "in equal footing") up to a 12% IRR. This means that the partners will split cash flows evenly until the LP achieves a 12% return - hurdle 1.
After this we will agree to a 50/50 split where the LP receives 50% and the GP receives 50% until the LP reaches a 15% IRR - the second hurdle.
Thereafter, all remaining cashflows will be split 30/70 where the LP gets 30% and the GP gets 70%.
(Development firms get increasing profit share to provide incentive to finish the project timely and effectively. It's also risk/reward share as they are the ones who have to guarantee the construction loan and usually take on the land before the development process even begins).
Similar waterfalls occur in private equity investment groups, and private equity firms usually receive disposition fees based on sale price if they can return a certain IRR to investors. For instance, my firm just sold a dog asset that we've had problems with for a few years, and we were worried that we wouldn't hit the necessary IRR to get our dispo fee which is a hefty chunk of change.
I went a little bit off topic there but thought it would give you some extra practical knowledge.
what has WSO turned into..