How to think of IRR in real estate?
Investing can be scary, especially if you are not comfortable with numbers and finance.
Even though you may not understand how different metrics are calculated or how they correlate, most seasoned investors key in on one specific metric to understand the return profile and compare various investments,
And that metric is called the IRR.
The IRR is one of the most heavily used return metrics in all of real estate and, in general, in the private equity(PE) world.
PE firms raise capital with estimations of a certain IRR number back to investors.
With the reputational risk, setting a target IRR value is one of the most important real estate valuation methods for all investors(not just private equity firms)
So, to help solidify this valuation method, let’s dissect IRR and what a decent IRR means.
But let’s expand a bit more on what IRR is.
The straightforward answer is IRR is your annualized return on investment over the lifetime of a deal but with a nuance. What makes IRR unique in comparison to other common metrics is that it takes into account the time value of money.
Let’s look at two examples:
Real Estate Transaction A:
-Make $50k in Year 1
-Make $150k in Year 2
Real Estate Transaction B:
-Make $150k in Year 1
-Make $50k in Year 2
At first glance, they may look to be the same return to you.
I invested $100k and got back $200k in total after two years.
Therefore I made a 100 % return on my investment or a 50 % return per year.
It is more complicated, though.
In A, after year 1, I have $50k to put in a new investment and start earning a return on.
In B, after year 1, I have $150k to put in a new investment and start earning a return on.
Therefore, all other things being equal, Project B is a better deal. It provides more money sooner, which allows me to compound my returns sooner.
You can see this when you calculate the IRR of both.
Project A IRR: 50.00 %
Project B IRR: 78.08 %
The example demonstrates how IRR calculates the annualized returns on invested capital over the deal's lifespan, accounting for all projected cash flows generated by the property.
In other words, the target IRR depends on the risk level, use of debt, and length of the property's hold period.
As previously stated, the IRR is the primary metric that investors utilize to evaluate if the expected return justifies the potential risk involved.
Predicting a good IRR is not an exercise done in absolutes.
When I first started, I wasn’t sure what to target, so I went down a rabbit hole to collate different offerings by other real estate investment firms to deduce a common benchmark.
My simple goal was to determine what some of the best PE and crowdfunding companies offered investors and compare offerings across many markers to arrive at the definition of good.
Here is a screenshot of my exercise:
Let's dive into the most common patterns I've found and where different types of real estate deals may fit.
If you are not using any debt:
The unlevered IRR, or the IRR without the use of any loans, generally fell somewhere between about 7% on the low end and about 12% on the high end for most real estate transactions, with a projected hold period of somewhere between 5 and 12 years.
Where you land up in this range essentially follows the law of high risk and high reward and is very much dependent on both the risk incurred and the estimated hold period of the deal.
For assets with higher risks and planned for shorter holding periods, it fell on the higher end of the return range, and lower-risk assets planned to be held long-term fell on the lower end of the range.
When you are not using a loan, an investor’s risk of loss is low, and because of that, investors in these deals generally are OK to accept lower returns.
So, a suitable target IRR for a low-risk, unlevered investment might be just 7%, while a high-risk, opportunistic asset (like a ground-up development deal or major rehab play) would need to have a target IRR of closer to 12% for investors to consider it.
If you are using debt:
Most real estate deals are acquired with some loan on the asset, so the levered IRR target will generally be the most pertinent for real estate investors.
The IRR, in this case, will generally be higher than the unlevered IRR for that same deal and often fall somewhere between about 8% on the low end to about 19% on the high end for that same 5 to 10-year hold period.
The same law of high risk and high return will apply here.
Lower-risk, long-term acquisitions of new assets in high-demand markets will generally see lower return expectations from investors because of lower perceived risks.
While higher-risk, short-term exits or development opportunities or a heavy renovation or lease-up generally see higher return expectations from investors.
And for loaned deals, the return range tends to be larger than in the unlevered scenario because different debt levels amplify returns at different magnitudes.
This means that, while a low-risk deal can keep the danger of default low by utilizing a higher LTV ratio like 35%, such a minor percentage of the deal being financed with debt might only get that 7% unlevered IRR to an 8% IRR.
But conversely, a higher-risk deal might be willing to take on an additional level of default risk in exchange for more increased upside on the back end of the deal with an LTV ratio of 75%.
Meaning the investors might be able to take that 12% unlevered IRR up to a 19% levered IRR, provided all goes as planned on the deal.
Return of capital timing is a big consideration.
The IRR includes a time value of money calculation, as I explained earlier.
And with that, the timing of cash flow matters a lot, and the earlier cash flows are received, the higher the IRR on a deal will be.
This means that an earlier exit date on a deal will result in an earlier return of capital, which can increase the IRR value for a 3-year hold significantly higher than the 10-year hold projection, even if both scenarios have very comparable projected cash flows.
That said, when setting a target IRR for a deal, investors will also consider the estimated hold period on the asset, which again increases the IRR expectations for shorter hold periods and decreases the IRR expectations for longer hold periods.
Putting This Into Practice
Overall, the two most crucial asset-based factors when setting a target IRR value on a deal are going to be
- the risk profile of the deal being acquired or developed
- projected hold period of the investment.
My take is that if you find deals where the IRR is on the higher end of the range mentioned above, it would be considered a decent deal, especially in todays market.
If you come across higher IRR numbers outside of the range mentioned above, it most likely reflects some inherent risks, so be extra diligent and understand the consequences if the deal were to go wrong.
Your experience, system, and team will also improve the IRR numbers. For example - I only aim for a deal with at least 16% IRR because of my experience.
With every deal, my risk appetite goes up.
That’s a wrap - I hope this helps.
If you made it all the way down here, thank you! I really appreciate people reading.😊