A Layperson’s Explanation of IRR (Internal Rate of Return)

May 31, 2017

A Layperson’s Explanation of IRR (Internal Rate of Return)

Investing can be intimidating, especially if one is not comfortable with finance.  Even though we may not understand how different metrics are calculated, or worse, how they correlate, most of us key-in on a couple of metrics to use for comparing investments.

In the public markets, the most common comparisons the average investor uses are the simple rate of return (ROR- gain or loss in stock price over a period), or the P/E ratio. In real estate, the most common metric used is called Internal Rate of Return (IRR), but unfortunately this metric is often confusing and misleading and should not be used alone in comparing investment options.

With stocks, you buy at one price and hold it until you sell, so it is easy to calculate the rate of return, but because real estate investments often take in equity over irregular time periods, and pay out cash over irregular periods of time and in irregular amounts, a more complicated formula is needed.

Many people make the mistake of assuming IRR is the same as compounded rate of return, it is not. A common definition is: The Internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested.

The biggest problem with using IRR by itself for comparing investments, is accounting for the periods of time, return of principal, and return on investment. Two investments, each with an IRR of 10%, can produce a materially different return on investment.  Unless you know when and how much both investments are going to pay out, IRR is not a prudent metric to use for comparing investments. 

It may be easiest to understand by looking at a side by side comparison of two investments that each have a 10% IRR; one where the return is paid entirely at the end of 5 years and one where the return occurs each year over 5 years.

The first example assumes the 10% annual return is reinvested and will compound, but the second assumes any amount paid above a 10% annualized will be considered a return of equity, thereby reducing the principal amount invested for subsequent years.

In conclusion, as demonstrated in the example above, it is not prudent to simply use IRR as the only metric for comparing real estate investments. IRR is a good starting point, but understanding the time periods and amounts distributed is integral for an accurate comparison.  Using the additional metrics of ROR, Annualized return, and Multiple will ensure a more accurate comparison.

This post was written by Danny Mulcahy, Director of Equity at Northstar Commercial Partners. If you have any questions, feel free to comment below, or contact him at danny@northstarcp.com.