IRR in commercial real estate: how to calculate and interpret it

What is IRR in commercial real estate?

IRR takes two inputs: the operating cash flows projected across the hold period, and the initial cash outlay to acquire the asset. It returns the annualized rate of return earned on that purchase price. What makes it useful in property is that it weighs timing as well as amount. A dollar of cash flow received in year one lifts the IRR more than the same dollar received in year five.

In real estate we're often given a set of cash flows (in the form of rent rolls, expenses, etc. that are relatively static) and market conditions (market cap rate, for example) that determine the current "market value" of a property.

Although there are inefficiencies in the market that can be exploited by real estate operators, for the purpose of illustrating the use of IRR here we'll assume an efficient market where rents, occupancy, and the given cap rate for a property are at market rates and no arbitrage opportunity exists.

A simplified explanation of IRR is that it takes two inputs: one is the set of assumed operating cash flows over the hold period and the other is the estimated initial cash outlay (purchase or acquisition price). The IRR calculation then discounts the assumed operating cash flow year-by-year and returns the rate of return that will be achieved on the given purchase/acquisition price. So, the IRR accounts for both the amount of the cash flow as well as for the timing of the cash flow.

Table 3 below provides a simple example of the IRR at work. In this example, an investor invested $100 at the beginning of year one and expects to receive $25 in cash flow at the end of each of the next five years. Given these assumptions, the investor should expect to achieve an annualized rate of return of 7.93% on the $100 investment.

Table 1: Internal rate of return

How the time value of money drives the IRR calculation

IRR rests on the time value of money: a dollar today is worth more than a dollar in five years, because today's dollar can be put to work in the meantime. That relationship runs in two directions. Future value asks what an amount invested today will grow into. Present value asks what must be invested today to reach a target amount later. IRR uses present value logic, working backwards from projected cash flows.

IRR can be confusing for those new to it, both mathematically and conceptually. In order to get a better feel for what IRR does, we need to spend a few minutes talking about the time value of money. The time value of money works in two directions: looking forward with “future value” and looking back with “present value.”

To determine the future value of an initial investment we apply a rate of return to the investment over the investment hold period. Table 1 below illustrates this concept on a $100 investment held for five years at a 5.0% annual rate of return. If $100 is invested today at an annual 5.0% interest rate, then the investment will grow at 5.0% each year and after four years the investment will have grown to $121.55. Thus, the future value of $100 invested at a 5.0% annual rate of return is $127.63. We cover that concept in more depth in our article on how the time value of money applies to CRE valuation.

Table 2: Future value

The present value calculation works in the opposite direction. Rather than asking how much an investment today will grow into in the future, we ask how much we must invest today at a given interest rate in order to achieve a specific future value amount.

Table 2 asks how much we must invest today at a 5.0% interest rate in order to have $100 five years from now. This calculation starts with $100 five years from now and incrementally works backwards until we see the amount that must be invested today, the present value, of  $78.35.

Table 3: Present value

Notice that both of these methods, future value and present value, require a rate of return in order to determine the respective answer. This is a great approach when the rate of return is known, but, as we’ll see in the explanation of the IRR below, what we often want to figure out is what return will be achieved from a given set of cash flows rather than what cash flows will be received from a given rate of return.

How to calculate IRR on a commercial property

A property IRR is calculated on net cash flow, not net operating income. Start with NOI, deduct capital expenditure, leasing costs and debt service if you are modeling a levered return, then add the net sale proceeds in the final year. Enter the initial outlay as a negative figure in year zero and solve for the rate that sets the net present value to zero.

The step most often missed is the exit. A property held for five years does not simply stop producing cash in year five, it is sold, and those proceeds usually make up the largest single cash flow in the model. Leaving the reversion value out understates the IRR substantially. The sale price is normally estimated by applying a terminal cap rate to the year six forecast NOI, then deducting selling costs.

In practice nobody solves the equation by hand. Spreadsheets use the IRR function for cash flows spaced evenly a year apart, and XIRR where the dates are irregular, which is the more realistic case once you account for a mid-quarter closing or a phased capital program. The mechanics of building the underlying cash flow model are covered in our article on discounted cash flow in real estate.

Levered versus unlevered IRR

Unlevered IRR measures the return on the property itself, using cash flows before any debt service. Levered IRR measures the return on the equity invested, so loan proceeds are added at acquisition and debt service is deducted each year. The two answer different questions. Unlevered IRR tells you whether the asset is a good asset. Levered IRR tells you whether the deal is a good deal.

When the cost of debt sits below the unlevered return, leverage lifts the levered IRR above the unlevered figure. That gap is the reason levered IRR is the number most often quoted in an offering memorandum. It is also the reason the two should never be compared directly. A levered IRR that looks strong next to an unlevered one is not evidence of a better asset, only of more borrowing, and the same leverage that magnifies returns on the way up magnifies losses if income falls short of the debt service.

When you are handed an IRR without a label, ask which one it is before you compare it to anything.

What is a good IRR in commercial real estate?

There is no universal answer. A target IRR is set by the investor's strategy, the risk of the asset, the amount of leverage and the length of the hold. Core strategies on stabilized assets carry the lowest targets. Value-add and opportunistic strategies carry the highest, because they take on execution risk. An IRR is judged against the investor's hurdle rate, not against an industry average.

The hurdle rate is the minimum return an investor or fund requires before committing capital. If the projected IRR clears it, the deal is worth pursuing. If it does not, the investor either walks away or revisits the price. That is the whole test, and it is specific to the buyer rather than to the market. It is closely tied to the rate you use to discount cash flows in the first place, covered in our article on the discount rate in commercial property valuation.

Two conditions have to hold before comparing IRRs at all. The hold periods must be similar, and the leverage assumptions must match. A five year IRR and a twelve year IRR are not comparable figures even when the underlying assets are identical, because IRR is an annualized rate and rewards capital returned early. Comparing a levered projection to an unlevered one has the same problem. Where those conditions do not hold, the honest comparison is on net present value instead.

IRR versus equity multiple

Equity multiple is total cash returned divided by total cash invested. It ignores timing entirely. IRR is sensitive to timing and says nothing about scale. A deal returning 2.0x over three years and a deal returning 2.0x over eight years have the same equity multiple and very different IRRs, which is why investors read the two together rather than choosing between them.

The distinction matters most on short holds. A quick refinancing or an early sale can produce an impressive IRR on a small absolute profit, because the capital came back fast. The equity multiple exposes that immediately. Conversely a long hold on a stable asset can show a modest IRR while returning a large multiple of the original equity. Neither number is complete on its own.

Where the IRR calculation falls short

IRR carries three known limitations. It assumes cash flows received early are reinvested at the same rate as the rest of the projection, which rarely happens. It reports a percentage and therefore says nothing about the size of the profit. And it is only ever as good as the assumptions behind the cash flow model that produced it.

The IRR approach to valuation is very useful, but the calculation itself has one drawback. The formula assumes that cash flows received earlier in the analysis are re-invested at the same rate of return as the rest of the cash flows.

This is often not the case because investors will sometimes reinvest funds in other projects at then-current market returns rather than reinvest funds in the same property. An analyst needs to be aware that this factor could cause the IRR to be slightly off from the actual return received.

The second limitation is that IRR is blind to deal size. A 25% return on a small equity check and a 15% return on a much larger one produce very different amounts of profit, and the higher percentage is not automatically the better outcome for a fund with capital to deploy. The third is more basic. Every input in the model is a forecast: rental growth, occupancy, capital expenditure, exit cap rate. Change the terminal cap rate by a quarter of a point and the IRR moves noticeably. Running the projection across a range of exit assumptions rather than a single point estimate is what separates a defensible IRR from a number on a page. Once the asset is owned, commercial property asset management software such as ARGUS Asset Manager tracks NOI, IRR, and value against those assumptions as leases and expenses change.

IRR compared with NPV

NPV and IRR use the same cash flows and answer opposite questions. NPV fixes the required rate of return and solves for what the property is worth. IRR fixes the purchase price and solves for the return that price will deliver. Use NPV when you are setting a bid. Use IRR when the price is already known and you are testing it against a hurdle.

• The NPV method sets a rate of return in order to determine the purchase price of the property.

• The IRR method uses a purchase price to determine the likely rate of return given the assumed cash flows (both outflows and inflows).

While both the NPV and IRR methods are extremely useful, in practice the IRR method is generally a more viable approach. One of the reasons for this is that an investor rarely has the ability to change the purchase price as they see fit. The purchase price is determined by the market and if the market price on a specific asset does not allow an investor to achieve the desired rate of return, the investor should move on to another property or rethink the rate of return they currently require.

The IRR method takes a more realistic approach to determining the expected yield given current market conditions and can be used to quickly figure out whether the combination of cash flows for a property and a probable purchase price offer the rate of return an investor finds acceptable. If an investor does not find this return acceptable, they can quickly move on to another property or market that does offer the desired rate of return. For the mechanics of the NPV calculation itself, including how to choose the discount rate that drives it, see our full breakdown of net present value in commercial real estate.

Arguments for using IRR rather than NPV

While both the NPV and IRR methods are extremely useful, in practice the IRR method is generally a more viable approach. One of the reasons for this is that an investor rarely has the ability to change the purchase price as they see fit.

The purchase price is determined by the market and if the market price on a specific asset does not allow an investor to achieve the desired rate of return, the investor should move on to another property or rethink the rate of return they currently require.

The IRR method takes a more realistic approach to determining the expected yield given current market conditions and can be used to quickly figure out whether the combination of cash flows for a property and a probable purchase price offer the rate of return an investor finds acceptable. If an investor does not find this return acceptable, they can quickly move on to another property or market that does offer the desired rate of return.