We have used the internal rate of return – or IRR – for generations in commercial real estate investing.
After all, it does help investors cut through some of the market’s complexities. Additionally, it’s very useful in terms of deciding a project’s worthiness. That makes it invaluable when it comes to establishing budgets and setting priorities.
However, for all its popularity, the internal rate of return does have its disadvantages. Let’s take a look.
Tell me what IRR is?
First things, first. In essence, the internal rate of return is a metric used to determine a project’s current performance or the likely return rate of a potential project.
Another way to say it is, IRR is the yearly growth rate a project is expected to deliver.
Is IRR easy to calculate?
Yes, it is, if you use a calculator or Excel – which nearly everyone does — because the formula is complex. It leans heavily on “profit” and “time.”
You likely know what profit is. That’s not the complicated part. “Time,” though, is more dynamic, and has to do with external factors such as housing trends and over-time changes in the value of money.
With that, then, we use IRR to help investors understand an investment’s profitability or prospective profitability – in relation to “time.”
Benefits of IRR
That whole “relationship to time” thing is good because, with IRR, all future cash flows are mixed in with the calculation.
This means that every cash flow carries the same weight. This ultimately delivers a more accurate result.
Then there’s the ease of calculation, and the ability to compare properties in terms of expected profitability. We can use the tool to compare an investment to another one in a whole other field.
In addition, it’s also easy to use IRR along with an additional tool so that your result covers other angles IRR may not.
What are some disadvantages of IRR?
For one thing, IRR results do not include factors such as financial risk, inflation, capital costs, and the risk-free rate.
Even with a favorable result, it’s important to know that IRR does not factor in the possibility of, say, previously uncovered property damages. These can increase investment costs or cause an unexpected decrease in rental rates.
Also, IRR makes it challenging to determine – in real dollars – the amount of profit realized.
Why? Because there’s no way of knowing how much a $500,000 investment, that has an IRR of 9 percent over 30 years, is worth today. And that’s because we can’t know what $500,000 will be worth years from now.
In addition, IRR makes capital costs an essential part of its calculation. That can be a problem because the metric delivers an incomplete future view.
As well, there’s no consideration of a project’s scope or size, and the internal rate of return ignores potential costs such as fuel and maintenance.
And the fact that the internal rate of return does not consider reinvestment rates is another issue. After all, the assumption that the value of future cash flows can be reinvested at the same rate as the IRR is not always a good one.
Now that you know the disadvantages of IRR in real estate evaluation, you can still use the tool…assuming you take its shortcomings into consideration. After all, there aren’t that many viable metrics in real estate out there.
You may even wish to use IRR with another instrument so that you cover all your bases.
If you want to learn more about IRR and real estate, consider contracting the alternative platform Yieldstreet, which has resources you’ll likely find helpful.