Trying to understand the concept of IRR

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?

Comments (37)

May 31, 2017

Read this thread. Should answer your questions.

https://www.wallstreetoasis.com/forums/relationshi...

May 31, 2017

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.

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May 31, 2017

Think of IRR as the variable in this situation. You set one side of the equation (NPV) equal to 0 and the other (the cash flow function) should have a variable on that side for the discount rate/IRR. Solve for the discount rate/IRR that satisfies that equation. With weird cash flow timings/amounts, you could have multiple IRR values that satisfy the equation, I believe, which is why most textbooks will recommend you fall back on NPV to make investment decisions in these cases.

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May 31, 2017

The discount rate is what you want. The IRR is what you get. The NPV quantifies the difference.

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May 31, 2017

Nice, but I would say that the discount rate is what you expect, not really 'what you want.'

    • 1
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May 31, 2017
Esuric:

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.

Best Response
May 31, 2017

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.

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May 31, 2017

This was extremely helpful thank you. I do have a follow-up question though:

Can an investor look at the IRR similarly to how he/she would look at the rate of return?

For example, an investor would obviously prefer to have a higher rate of return (ex: An investor would rather want a 20% rate of return vs. a 5% rate of return.)

However, would this same concept work for the IRR? Can investors think: Project X would produce a greater IRR than Project Y, therefore, I will pursue Project X. Or can you not think like this?

Whatever it takes.

May 31, 2017
Rchan100:

This was extremely helpful thank you. I do have a follow-up question though:

Can an investor look at the IRR similarly to how he/she would look at the rate of return?

For example, an investor would obviously prefer to have a higher rate of return (ex: An investor would rather want a 20% rate of return vs. a 5% rate of return.)

However, would this same concept work for the IRR? Can investors think: Project X would produce a greater IRR than Project Y, therefore, I will pursue Project X. Or can you not think like this?

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.

May 31, 2017

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.

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May 31, 2017

To make it even simpler, think of it this way.

When you are underwriting a deal, those are speculative cash flows (very likely, but still speculative, as they have not occurred yet.) There could be unforeseen fires, vacancy problems, increase in tax assessment, etc.) You are using WACC to discount because that's your MINIMUM required return due to you debt and equity liabilities.

When you sell the deal and realize the gains, you now have concrete, actual cash flows that have occurred in the past. The IRR is therefore your actual, realized return. Go back and discount those cash flows at your return, and NPV will be 0 (obviously).

You are simply using the WACC during initial underwriting stages to make sure you are able to fund your capital responsibilities. i.e. to see if the deal even works (NPV >= 0)

Slow day at the office..

    • 1
Jun 2, 2017

what has WSO turned into..

    • 3
Jun 6, 2017

Cost of capital is your discount rate, not IRR.

Jun 6, 2017

IRR is a return measure. A 25 percent IRR is telling you that you'd have to invest in a bond yielding 25 percent to get a similar return as the deal you're looking at.

It also lets you rank deals ie a 25 percent deal doesn't return as much as (the probability weighted returns of) a 30 percent deal. Other things being equal, you'd choose the 30 percent deal.

But bear in mind IRR is not well adjusted for risk. Theoretically, risks are reflected the probability weighted cash flows, but it's rare they actually are.

Jun 2, 2017

From other topic:
"Currently working at a Hedge Fund (Global Macros) as a marketing/Investor Relations Intern and also a property manager.
Locked in RE Analyst offer with SIP. Saw the nuts and bolts which included RE Modeling of Pro formas, RR Analysis, Payroll, etc.
Interned at several other RE companies such as Loews Corp., etc.

HBX Core Program, RE Licensed Salesperson, Bloomberg Certified, Notary Public, CEO of a small marketing company, Finalist for a Couple of Competitions"

How the hell did you even get those internships without knowing what IRR is?

Jun 6, 2017

Just a guess.

Jun 6, 2017
Jun 6, 2017

It is a place holder for your best guess of the IRR and it defaults to 10%.
Since the irr calculation is iterative it can reduce calculation times and make a sheet more efficient (very minor)

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Jun 6, 2017

I would take a step back and focus on what IRR and NPV is used for. It is used to value investments. But NPV gives you a dollar amount, while IRR gives you a %. They are also interpreted differently: NPV is more straight forward, it gives you a dollar amount; IRR gives you a % and it means it takes x% to get to NPV =0 or it would take an interest of of x% before you earn $0 on that investment, which means the higher IRR the better

Jun 6, 2017

I see you're looking for quite a number of answers. My suggestions would be to learn how to deal with them independently so you can keep doing them yourself...

"Give the man a fish and he eats for a day....." you know how it goes.

Anyways, just get a financial calculator and it shouldn't take you no more than 30 seconds

"Suffer today and live the rest of your life as a champion!"

Jun 6, 2017
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Jun 7, 2017