Internal Rate of Return (IRR) is a valuable tool used across the real estate industry. By boiling down profitability to a single interest-rate equivalent, IRR facilitates the economic comparison of projects with different funding, holding and distribution patterns.
Unfortunately, IRR is miscalculated all too often by analysts who assume they can convert the value generated by their spreadsheets for monthly or quarterly periods to an annual IRR by multiplying by 12, or 4, respectively. Beware, this approach understates the actual IRR.
Taking a pass on good?
Imagine you are considering the purchase of a three-lot parcel of land for $1 million. You believe you can sell each individual lot for $550,000. Your company's policy is that only land deals that underwrite to a 35% or better forecast annual IRR can be pursued.
Your analyst underwrites the investment with an initial investment of $1 million and sales proceeds of $550,000 at the end of the 16th, 20th and 24th month. This cash flow indicates a 2.55% IRR per monthly period. Your analyst multiplies this figure by 12 and says the investment will generate a 30.6% IRR.
Do you take a pass on the transaction? That would really be a shame since this transaction actually offers a 35.3% IRR, if calculated properly.
Now imagine that your company has no IRR policy and decides to proceed with the acquisition of this three-lot parcel. You invite some limited partners to invest in this transaction. Your operating agreement with your limited partners provides that your company, the general partner, will contribute 10% of the equity and the limited partners will contribute the remaining 90%.
It also provides that proceeds from lot sales will be distributed on a pari passu basis until all partners have had their capital returned and have realized a 20% IRR. Then additional sales proceeds will be shared — 50% for your limited partners and 50% for you. All distributions are to be made at the time of the sales.
Your sales and timing projections turn out to be spot on, and the project generates a $650,000 profit. Your analyst calculates that a 20% IRR is achieved after $1,371,500 in sales proceeds have been distributed. At that point, your company would have received $100,000 in returned capital, and $37,148 in profits. Of the remaining $278,852 in profits, you take 50%, or $139,426, for total profits of $176,574. You feel pretty good about the project, which you believe generated a 59% return. Not too bad.
Well, maybe it was too bad you didn't calculate your IRR correctly. If you had, your profits would have amounted to $191,200, and you would have realized your actual IRR was 82%. Although you would pay your investors $14,625 less, you would be able to inform them that their IRR was 28.8% instead of the 26.2% you would have otherwise reported.
Demystifying the calculations
If IRR is calculated from a cash flow of monthly disbursements/receipts and is converted to an annual IRR by multiplying by 12, the annual IRR is understated. That's because multiplying by 12 only adds up the monthly receipts and does not recognize the potential to re-invest those receipts received during the year.
If you invest $100 for one year and you receive $112 at the end of that year, you would correctly conclude your IRR was 12%. But what if you received 1% each month? If you multiply that 1% by 12, you might conclude your IRR was 12%. But would you be equally happy with either investment? No. If you'd received funds during the year, you could've spent or re-invested them.
The formula to convert monthly IRR to annual IRR taking this reinvestment opportunity into account is provided in theabove.
Don't forget to work with your counsel to ensure your documents provide you with the ability to utilize those correct calculations. An undefined phrase like “annual IRR” is potentially fuel for a dispute between you and your investors when you should instead be celebrating your project's success.
Robert D. Ginsberg is an assistant professor at New York University and managing director of Caramoor Capital Group Inc. Contact him at RobertGinsberg@CaramoorCapital.com