IRR isn’t complex and you need it

Written May 1st, 2013 by

Time Value of MoneyIRR, or Internal Rate of Return, is a powerful calculation to measure the effective rate of return (aka yield or interest rate) of an investment.  It takes into account unequal distributions (cash flows) over time, and calculates the return each dollar in the investment makes while it is still in the investment.

Simple to grasp; tough to compute

Some people find IRR daunting, as it is complex to calculate by hand.

But, IRR represents something very basic: the annual return from your investment calculated over the ownership period.

Time Value of Money

Money is more valuable today than tomorrow.  First, money that you receive today can be invested somewhere else, and earn a return.  Second, inflation reduces the buying power of money in the future.  For these reasons, an investment has a better effective return if it returns money sooner, rather than later.

IRR takes this into account, and will calculate a higher return on investments that pay out sooner.

As a simple example:

  • If $1 is invested today, and $1.10 returned one year from now, the IRR would 10%.
  • If $1 is invested today, and $1.10 returned two years from now, the IRR would be 4.9%.
  • Since the 1st investment returned money sooner, it has a higher annual return, and thus higher IRR.

Example of fixed return

It is straightforward to calculate the IRR of a fixed return.

For example, if 10% is paid every year, then the IRR is 10%!

  • Year 0 = $1 investment
  • Year 1 = $0.10 distribution
  • Year 2 = $0.10 distribution
  • Year 3 = $0.10 distribution and $1 is returned

Example of unequal distributions

IRR is really powerful for cases where there are uneven distributions, or when you don't receive back the exact amount of money you put in.

For example, in the case below, the IRR is also 10%

  • Year 0 = $1 investment
  • Year 1 = no return
  • Year 2 = no return
  • Year 3 = $0.33 distribution and $1 is returned

As there was no return in years 1 and 2, the investment needed to pay a much larger distribution ($0.33) in the final year to keep the same 10% IRR.

Why you need it

IRR is a great tool to determine whether a particular investment makes sense for you, when compared against investment alternatives.  For example, if an investment has a 7% IRR, and you have alternatives that generate >7%, then it may not be a good investment for you.

IRR is also great for analyzing investments that don't return much money in the first few years.  This can be very common in multifamily investments where a distressed property is acquired, and doesn't cash flow strongly until year 2 or 3.  Let's take the following example:

  • Year 0 (Investment) = $1
  • Year 1 = no return
  • Year 2 = 5% ($0.05)
  • Year 3 = 15% ($0.15)
  • Year 4 = 15% ($0.15) and $1 is returned

At first glance, this appears to be an awesome investment (15% distributions!).  Unfortunately, the big returns are delayed a few years.  As a result, the IRR of this calculation is 8.2%.  Thus, if you have an alternative investment that can pay the >8.2% every year (or over time with IRR), you may wish to invest there instead.

Calculation

Calculating IRR by hand requires performing a discounted cash flow analysis, and then iterating various rates until you find the one that creates a net present value of 0.  Don't worry what those terms mean -- the point is that it is complex!

Fortunately, there are tools to help us perform this calculation. it is built into 10bii calculators, and is also available as a function in Microsoft Excel (function IRR.)  Using these tools is beyond the scope of this blog post.  But, do a web search for "Excel" and "IRR", and you will find plenty of examples.

Caveats

While IRR is a very powerful tool, there are some limitations:

  • It breaks down if you have negative cash flows past the original investment.  
  • It cannot compare investments effectively that require different investment levels.  For this, you need to consider the return that unused money will achieve as well.
  • It does not comprehend the alternative investments where you will use money that is distributed by the investments.  If there is no place to put the money, you may not want to receive it sooner!
  • IRR does not comprehend risk -- it only calculates the effective return for a given set of assumptions.  A sensitivity analysis should be performed to calculate the impact of more conservative/aggressive assumptions.

Summary

It can be very difficult to understand how different companies calculate statistics such as "return on equity" and "average returns".  There are MANY different ways to calculate these, and they are often presented in a way that makes that particular investment look better.

IRR is not open to interpretation.  Not only does it remove the ambiguity associated with other terms, it also takes into account "when" distributions are made.  It is arguably the most powerful number available when comparing investments.

However, though IRR is a very accurate representation of returns when looking at past investments, it is only as good as its assumptions when looking at future investment opportunities.   It is one component in the due diligence process, and cannot be used blindly.  Make sure you understand the assumptions taken.  If they are too aggressive, the IRR calculation may look too rosy.  It may be prudent to get results from sponsors on past deals, before investing in a new investment.  What did they estimate as the IRR, and where did it really come in?

Good luck investing!

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