The internal rate of return, IRR, is the annual rate that makes the present value of all of an investment's cash flows equal to zero. In real estate it summarizes the return on equity over the whole hold: the money put in, the cash received along the way, and the proceeds of the sale.
How it is used
Investors and lenders use IRR to compare opportunities with different timing and structure on a single yearly rate. It is reported as unlevered (the property alone) or levered (after debt), and as gross or net of fees and promote.
What drives it
- The timing of cash flows. Cash that arrives earlier raises IRR, so a quick profitable exit produces a high IRR even on a modest profit.
- Leverage. Debt reduces the equity needed, which can raise IRR if the property earns more than the debt costs.
- The exit assumption. For most real estate holds, the sale accounts for much of the total return, so the exit cap rate and the exit year change IRR substantially.
What it ignores
IRR does not show how much money is made, only the rate. A 25 percent IRR on a small amount held for one year can return less cash than a 12 percent IRR held for ten. It also assumes interim cash can be reinvested at the same rate, which is often optimistic.
Read it with the equity multiple
The equity multiple, total cash returned divided by cash invested, shows the size of the outcome that IRR leaves out. Showing both, with the assumptions for rent growth, expenses and exit, lets a reader judge the return rather than accept it.