Don’t be Jedi mind-tricked by IRR

IRRs show up a lot in proforma in real estate syndication marketing materials. It would be very remiss of us not to address it (and get it over)! To spare us all the agony, I don’t intend to rehash academic examples in this blog – I am sure you can easily find those in books and on the internet. I’d like to focus on the implications for applications instead. IRR is useful as a rough performance indicator but that’s where it ends. One should appreciate IRR for what it is while understand its shortfalls and limitations, including its “gameability”.

What is IRR (Internal Rate of Return)?

Bear with me on the textbook definition here:

• IRR is the discount rate that causes the net present value of all cash flow to zero
• Said another way, it equates the present value of an investment to the present value of all the returns from that investment

IRR is a cash-weighted (or dollar weighted) measure, meaning its value depends on, and varies based on, both the timing and size of cashflows into and out of an investment – which also plays into its gameability by managers.

Why is IRR a commonly accepted performance metrics for private equity, and by extension, private real estate syndications?

Despite the shortfalls & limitations described below, IRRs are still very much embraced as performance metrics for illiquid investments when regular interim valuations are not available or reliable:

• PE and private real estates deal are illiquid and opaque. There’s no exchange like Nasdaq or NYSE and the likes for private equity deals, certainly not for private real estate syndications, that one can see published quotes on where things are trading.    Those who work in CRE full time, such as brokers and lenders, might have ideas on where generally things are priced, related to the segments of CRE markets they focus on.  Transparency of valuations and data on the assets/collaterals are not readily available to the uninitiated.  
• Relative to their public securities counterparts, private equity sponsors (the GPs) typically exercise a greater degree of control over the timing and size of cash deployment; in public markets, even mom & pop retail investors can move in & out of a security with relative ease. This lends IRR to be more suitable calculation of returns than say a time-weighted return, such as holding period return
• PE mangers still need a quantifiable metric to measure and report performance; IRRs are relatively easy to calculate (with functions in Excel) and hence widely adopted
• Real estate investing cashflow patterns generally fit the IRR calculation framework due to the typical stages of cashflow:
  • an initial cash outlay, representing the purchase/investment of an asset
  • a series of cashflows during the hold period
  • a terminal value at time of exit, through a sale or refinance

Why is IRR of limited use?

This is not an exhaustive list of shortfalls/limitations of IRRs but come that come to mind:

• IRR assumes the interim cashflows (i.e. distribution) can be reinvested at the same IRR, or in an investment with identical future return.     (When you figure out how to accomplish this, I’ll love to hear from you.)
• If you have a healthy dose of FOMO (fear of missing out) and tend to look at a few deals before pulling the trigger, IRRs do a poor job for comparison purposes. The same stated IRR% level from syndications with different holding time, project size, underlying assets, managers are not really comparables:
  • Some deals investors are required to meet a series of capital calls at certain phases v. some investors only need to dough out in the beginning
  • Some developments or heavy value-adds will go through long stretch with little to no cashflow v. some offer more stable distribution v. some produce lumpy cashflow.  The point is cashflow patterns are all over the place, due to type of projects, strategies, how a deal is financed. Literally no two deals’ cashflow are identical.  It makes comparing IRRs across syndications difficult, or, in some cases, darn right hard to interpret even a single IRR.
• In proforma, IRRs (outputs) are predicated on sets of assumptions (inputs) projected several years out which lend to the situation of “garbage in, garbage out”. Note all metrics calculated based on assumptions suffer from this; it is not unique to IRR.

If not IRR, then what?

• In terms of performance metrics, don’t get fixated on IRR alone. Look at other metrics, such as Equity Multiple (EM), and Cash-on-Cash (CoC).  They have their respective limitations but nonetheless are compliments to IRR and should be looked at in conjunction with IRR.
• Know thy Sponsors! I can’t emphasize enough the importance of investing with the right Sponsors who have integrity, ones who don’t need to pretty-up their proforma to raise capital. They are selective not only in the deals they do, but are prudent in their underwriting and conservative in presenting their opportunities to investors. They rather under-promise and over-deliver. The right Sponsors tend to pick the right projects, finance, manage right and deal righteously with investors. The return will take care of itself.
• Dig Deeper – Know Thy Investments & know Thyself! Understand what it is that you are investing in, the projects’ risk & returns, how they sit with the overall macro & real estate cycle. Just as important is how they fit (or not) into your overall portfolio; definitely understand your own needs as an investor. This goes back to setting your investment criteria, knowing that not every good investment is suitable for you, at a particular market cycle, at a particular juncture of your wealth-building phase. Splitting hair on which deal(s) to deploy your capital over decent enough IRRs while ignoring other glaring red flags might even steer you down the wrong path. As with all mantra, its often easier said than done.

Want to learn more about how to analyze real estate syndications as passive investor or even learn to do your own deals as GP (be on the active side)?  Contact us to see how we could help you.