Managing Partner, Capital Markets at PIA Residential.
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As a real estate private equity firm operating in the multifamily acquisition space, my company receives an abundance of feedback and questions regarding our predictive financial modeling. One of the most prevalent questions is regarding the returns. We are often told by investors that they “see opportunities with a much higher IRR”; however, they often fail to accurately compare each opportunity that is presented to them. At PIA, we believe it is paramount to provide our investors guidance and education on the proper ways to assess risk accurately.
Sponsors can willingly or accidentally manipulate return profiles to show inflated numbers. Assumptions are the backbone of the predicted returns and can lead to skewed projections. Unnecessary risk is assumed if there is poor understanding of the limitations and frequently used tactics associated with potentially inflated figures.
Unfortunately, responsible sponsors who make conservative assumptions to decrease the risk carried by their limited partners are often at a disadvantage when presenting their return profiles. To continuously attract capital and interest from the investor’s base, sponsors must exhibit honesty and integrity, and build trust by avoiding unnecessary risk and exceeding or living up to the original projections. Although the IRR does a fantastic job of showing the time value of the invested capital, it does not provide a complete view of the potential risk, unless combined with other metrics that allow opportunities to be pressure-tested to mitigate as much risk as possible.
Through an informal survey of 20-plus investors, we found that the great majority do not understand the concept of IRR and how the metric can be "manipulated." Savvy investors must learn to utilize several metrics to feel confident in their due diligence and understand the risk associated with each investment opportunity. After coming to this realization, we created the term “quality of IRR,” which basically splits the IRR into two components. One is the cash-on-cash generated by operations, and the other is the return derived from the sale event at the end of the investment period. It also analyzes the impact on risk and returns from events such as refinancing.
Essential Return Metrics To Combine With IRR And Their Limitations
As discussed in a previous article, real estate return metrics have unique limitations. Combined, they provide a clearer view of the risk in investment opportunities. Below I'll highlight several alternative metrics and their respective limitations:
1. Cash-on-cash: “a rate of return often used in real estate transactions that calculates the cash income earned on the cash invested in a property.”
Limitation: averages cash yields over the assets hold period. Cash flow can vary wildly from year to year, and investors should analyze when they receive these distributions in the hold period.
2. Equity multiple: “the total cash distributions received from an investment, divided by the total equity invested.”
Limitation: provides a snapshot of overall profitability; however, it doesn't consider the time value of money, the length of time the investor's money is tied up or the cash flow distribution throughout the project's lifetime.
3. Cap rate: calculated by dividing a property's net operating income by the current market value.
Limitation: The integrity of a cap rate is built upon the forward-thinking data set used in deriving NOI; with prognostications, there is a tremendous weight put on the assumptions the manager makes.
Limitations Of IRR
Individually, IRR has shortcomings that investors and managers would be remiss in ignoring. Below are a few examples of areas in which IRR falls short:
• The initial investment amount between investment alternatives is not considered.
• It ignores the actual dollar value of comparable investments.
• It does not compare the holding periods of like investments.
• It does not account for eliminating negative cash flows.
• It provides no consideration for the reinvestment of positive cash flows.
Financial Engineering And Potential Manipulation Of IRR
When considering equity investment opportunities, you must understand the risks of potential financial engineering — where the utilization of leverage and ambiguous data could be used to increase the bottom line. The IRR metric is certainly a target risking the quality of IRR. Here are several ways IRR can be engineered to consider:
• High leverage can also be a sign of engineering; if the LTV is higher than 80%, there isn't much room for the business plan to underperform without sinking IRR.
• Analyze the hold period and lockout periods for the sale of an asset. When the time horizon is minimal, it is much easier to show an inflated IRR.
• Be wary of investment managers who plan to refinance and solely pay the management team. If a refinance occurs, both the manager and the investor should benefit — look for lockout periods on refinancing.
Quality Of IRR: Critical Thinking And Understanding Risk
The focus on evaluating and choosing investment opportunities is aligning your risk tolerance with that of the sponsor. The need for prospective investors and managers to consider the quality of IRR and examine whether the profits justify the risk level is clear. We urge you to combine IRR with other real estate metrics, pursue transparency and realize the quest for risk-adjusted "after fee" returns.
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IRR Method – Advantages, Disadvantages
A brief explanation of advantages of Internal Rate of Return method is presented below.
1. It considers the time value of money even though the annual cash inflow is even and uneven.
2. The profitability of the project is considered over the entire economic life of the project. In this way, a true profitability of the project is evaluated.
3. There is no need of the pre-determination of cost of capital or cut off rate. Hence, Internal Rate of Return method is better than Net Present Value method.
4. Sometimes, the pre-determination of cost of capital is very difficult. At that time, Internal Rate of Return can be used to evaluate the project.
5, The ranking of project proposals is very easy under Internal Rate of Return since it indicates percentage return.
6. It provides for maximizing profitability.
7. Internal Rate of Return takes into account the total cash inflow and outflows.
8. It gives much importance to the objective of maximizing shareholder’s wealth.
Disadvantages of Internal Rate of Return Method
The disadvantages of Internal Rate of Return are listed below.
1. This method assumed that the earnings are reinvested at the internal rate of return for the remaining life of the project. If the average rate of return earned by the firm is not close to the internal rate of return, the profitability of the project is not justifiable.
2. It involves tedious calculations.
3. This method gives importance only to the profitability but not consider the earliest recouping of capital expenditure. The reason is that sometimes Internal Rate of Return method favors a project which comparatively requires a longer period for recouping the capital expenditure. Under the conditions of future is uncertainty, sometimes the full capital expenditure can not be recouped if Internal Rate of Return followed.
4. The results of Net Present Value method and Internal Rate of Return method may differ when the projects under evaluation differ in their size, life and timings of cash inflows.
Home » Pros and Cons » 12 Internal Rate of Return Method Advantages and Disadvantages
The internal rate of return, or IRR, is the interest rate where the net present value of all cash flows from a project or an investment equal zero. IRR involves positive and negative cash flows. It is used to evaluate how attractive a specific investment or project happens to be.
If the IRR falls below a required return rate, then investors know that the idea should be avoided or rejected. On the other hand, if it falls above the required return rate, then the risks of losing the investment are much lower and should be considered or accepted.
Every project can be evaluated using IRR calculations. Projects can even be compared to one another to determine which options are the best for investors.
Here are the advantages and disadvantages of the internal rate of return method to consider.
List of the Advantages of the Internal Rate of Return Method
1. It incorporates the time value of money into the calculation.
IRR is measured when you calculate the interest rate where the present value of a future cash flow equates to the required capital investment. That means all cash flows in the future are considered as part of the IRR calculation. That allows every cash flow to be assigned an equal weight when looking at the value of money from a time perspective.
2. It is a simple calculation.
IRR is an easy measurement to calculate. The information it provides makes it simple to compare the value or worth of various projects that may be under consideration at any given time. When calculated correctly, business owners are able to quickly see which projects would generate the most potential cash flows in the future. It is also possible to use IRR as a way to find cost-savings opportunities with future purchases or investments.
3. It offers a method to rank projects for profitability.
The goal of the internal rate of return is to maximize overall profitability. It is able to do this by allowing you to compare the positive or negative outcomes of all projects under consideration. You can then rank the results in order, from high to low, to evaluate which projects create the best possible chances to achieve cash flows that will lead to profitability. Because the calculation produces a percentage routine, the ranking process is very fast when compared to other forms of project evaluation.
4. It works well with other evaluation factors.
One of the biggest mistakes that is made with the internal rate of return method is that it is the only calculation used to evaluate the viability of a project. That action leads to a number of potential disadvantages. The IRR method is better used with multiple evaluation factors. That way, you’re able to compare the positive or negative percentages from this calculation to other business factors. That provides you with a better picture of the financial health of a specific project.
5. It is not linked with the required rate of return.
When using the IRR method, you’re able to compare it to the rough estimates generated by the required rate of return. This rough estimate is not used with the internal rate of return method which means the two common calculations are not linked to one another. That makes it easier to make a decision with fewer risks because there is more information available.
List of the Disadvantages of the internal Rate of Return Method
1. It can provide an incomplete picture of the future.
When using the IRR calculation, the cost of capital is not required to be part of the equation. Sometimes referred to as the “hurdle rate,” this figure is the required rate of return which would be needed to fund the project. Although this can be an advantage as the hurdle rate is sometimes a subjective figure, it can also sometimes be a confirmed figure. In that situation, the IRR may not provide an accurate estimated cost.
2. It ignores the overall size and scope of the project.
When using the internal rate of return method to compare projects, it is important to remember that this method does not look at the size or scope of the project for comparison. It will only compare the cash flows to the amount of capital being spent to generate those cash flows. If there are two different projects requiring very different levels of capital, larger projects tend to be under-valued compared to smaller projects when using IRR calculations. If this is the only tool being used, a business may find itself avoiding long-term projects which may offer much better cash flows over time.
3. It ignores future costs within the calculation.
The goal of the internal rate of return method is to determine a projected cash flow from an injection of capital. It does not account for the potential costs that may affect profits in the future. Many costs, such as fuel and maintenance, are variable for businesses over time. By ignore these future costs, the cash flows being projected may not be as accurate when evaluating the full scope of the project.
4. It does not account for reinvestments.
Perhaps the biggest weakness of the IRR calculation is that it makes assumptions that future cash flows can be invested as the same rate as the internal rate of return. In reality, the number generated by the IRR can be quite high. The number of opportunities which are available that would yield such a return are usually minimal at best, creating an unrealistic picture for some companies looking to maximize future cash flows.
5. It struggles to keep up with multiple cash flows.
The IRR calculation is a good evaluation of potential risk because it produces a simple positive or negative result when the equation is completed. If there are multiple cash flows involved with the calculation, then sometimes the internal rate of return method can be misleading. Although this issue can be somewhat tempered by creating an assumed reinvestment rate that is specifically added into the calculation (see Con #3) and by bringing in interim or intermittent cash flows, this is all based on assumption. If you add more variables into the calculation, you are reducing the overall accuracy of the IRR.
6. It requires calculations that are quite tedious for the average person.
To calculate the IRR for a project, you must use the same formula as the net present value to determine an outcome. That means you must be able to take the number of time periods by the net cash inflow during the time period over the discount rate. You must then subtract the total initial investment costs from the calculation, based on the idea that the net present value is equal to solve. There are several resources which take you through this calculation, but you will need to have the specific figures available to begin the calculation process.
7. It places the top priority of the calculation on profitability.
If your primary need is to determine future profitability, then the IRR method is a good calculation to consider. If you’re looking to see how fast you’ll be able to recoup your capital expenditure, then the IRR is not going to provide you with the information that is needed. It can be easy to think that you can recoup expenses faster on smaller projects when, in reality, some projects may not be able to fully recoup the capital expenditure since the future tends to be unpredictable.
The advantages and disadvantages of the internal rate of return method make it easy to compare some projects. In return, certain decisions may be easier to make. It must also be remembered that the information the IRR provides is somewhat limited and should only be used to compare projects of similar size and scope. Otherwise, the information generated by this calculation may not be as beneficial as it appears to be.