The IRR Trap: Why the Internal Rate of Return Can Be Misleading in Real Estate Investing
We all love an easy lesson. Sometimes these recitable lessons even make sense for real estate investors. Sayings like, “Don’t bet more than you can lose,” “Measure twice and cut once,” and “Don’t put all your eggs in one basket” can all provide applicable guidance. But beware believing every piece of homespun wisdom. A bird in the hand may be worth two in the bush, but in real estate investing, “Money today is better than money tomorrow” might not be the best advice to take when it comes to your investment portfolio.
Should you rely on the IRR to guide your real estate investments? Image source: Wikimedia Commons user Hequals2henry
This saying comes into play when we talk about the Internal Rate of Return (IRR). This is a fairly complicated investment tool/strategy that is very big, one might even say “trendy”, in real estate. And while there is inarguably a place for it when looking at your overall portfolio, there are also risks, and an overabundance of caution can sometimes be harmful. At Origin Capital, we have years of experience in determining which models need to be applied where, and we understand that one size almost never fits all.
Understanding the Internal Rate of Return
The Internal Rate of Return is essentially the idea that the money you have today is worth more than the money you have tomorrow. That means that the key to understanding the worth of an investment is not just how much money you will receive, but when you will receive it, with the idea being that the earlier you receive it, the better. That’s a simple way to look at it, but in reality, it’s about more than just cashing out early.
In our business, we make sure to take the long and broad view because the real estate market is never precise. We know of investors who think that they have everything figured out, and don’t even feel the rug being pulled until it is already out from under them.
The broader view of it comes with a little bit of math, which we’ll make very simple. Say you have a chance to make a $500,000 investment in one of two properties based in Charlotte. For the sake of example, we will assume they are both going to double over a set period of time. According to IRR, you should use discounting to decide which is the better investment. Let’s say that in the first investment, you can be paid off in five years, and in the other investment, you can be paid off in 10 years. Taking interest rates and working backwards in time can help you determine which resulting million dollars is worth more. The theory is that the one you get sooner is worth much more.
On the surface, of course, this makes sense. Inflation means that a dollar today is worth more than one tomorrow (this is the “Time Value of Money”). Additionally, there is the idea that if you have this money today, you can reinvest it, or even just deposit it, so you can reap the rewards of a positive interest rate. All in all, IRR says that going with the first investment option is a slam dunk and a no-brainer. Right?
How the Internal Rate of Return Can Be Misleading
Of course, in real estate, as in life, nothing is ever so cut-and-dried. Here are a few factors that IRR doesn’t take into account, which will give you a more complete picture of your investment.
Net present value: One of those factors is “net present value” (NPV). NPV is simply the difference between cash inflow and cash outflow. This can have a huge impact on IRR down the line, as the NPV is always changing. It can be calculated and projected, but there are always unexpected occurrences. This is where it can get misleading, because it shows that a higher IRR doesn’t always make for a higher return. What matters is capital at the end of a project.
For example, let’s compare two projects. One has a projected IRR of 15%, and the other has a projected IRR of only 11%. The initial investment in both of these is (for the sake of numbers) $2000. The IRR with 15% reinvests at approximately $400 per period, assuming 10 periods. This is steady and consistent, but not spectacular. At the end, you have approximately an $800 profit.
The second project doesn’t involve reinvestment – instead, you wait until the end. At 11%, the NPV is around $6000. That gives you around $1000 of profit. Now, some people are uncomfortable if they’re not getting steady returns throughout, but there are many cases where waiting is the smart thing to do.
Unexpected expenses: Some real estate projects need more capitalization to be successful, and it can be impossible to predict that need. The unexpected can happen and then everyone is out of luck. When calculating IRR, the potential need for additional capital isn’t always taken into account. For example, think back to Hurricane Sandy. Among the widespread destruction, a crane that was working on the tallest luxury condo in NYC snapped, dangling dramatically and dangerously over West 57th street. This cost hundreds of thousands of dollars to repair. That is a rare case, but dangers can happen anywhere, and storms, both real and metaphorical, can always blow in. The perfect model can become an albatross.
Project size and complexity: Investors don’t always thoroughly analyze the complexity and inherent risk in real estate projects, which means IRR calculations can be sterile and somewhat removed from reality. A potential partner of ours once told us a story about a building they were considering investing in around the Austin area. The primary investor promised a completion date of Oct 25th. Warning flags should have gone up with promises of such specificity. The IRR is based on a series of assumptions that don’t always play out in the real world. Our client decided to back away, which was smart, because they later found out that the building had been plagued by supply issues stemming from higher-priced gasoline than expected, which boosted shipping costs and led to supply delays.
At the end of the day, IRR calculations can be handcuffing. Basing every investment idea on IRR means that you can lose out on great opportunities because of time or assumptions about inflation and future market rates. Just as you don’t want to be the guy who waits to sell his pumpkin futures in November, you don’t want to pull out of the market too early, either. IRR doesn’t give you a full picture of the market, and sometimes it uses caution in place of common sense.
At Origin Capital, we believe in caution. We analyze all of our properties thoroughly and carefully, and do deep-dives in the cities and neighborhoods in which we want to invest. We don’t make light decisions with our money or the money of our partners. But we know which is the right caution, which is the right metric, and what to pay attention to and when. That’s how we’ve maintained our success in investing in multi-family buildings and commercial real estate across the country. Old sayings are great, but the best one is the simplest: do the smart thing, every time.
If you are a real estate investor looking to broaden your portfolio and join other investors in major developments, Origin Capital Partners would be excited to work with you. At Origin Capital Partners, we have a powerful connection with the cities we invest in, and we understand what makes them tick. We know which areas are booming and which commercial and residential investments will make the most sense moving forward. Our Funds deliver consistent returns, because we know how to make sense of the real estate market. Contact us today to talk about how your investments can grow with the city.
