Internal Rate of Return (IRR)
Also called: IRR, Levered IRR, Unlevered IRR
The internal rate of return is the annualized discount rate at which the present value of a deal's cash flows equals zero, making it the time-weighted compound annual return on invested equity.
IRR is the number institutional investors and investment committees anchor on because it accounts for both how much you make and when you make it. A dollar returned in year one is worth more than a dollar returned in year five, and IRR is the only common return metric that prices that difference.
That time sensitivity is also its main weakness. IRR can be inflated by an early capital event such as a refinance or a partial sale, even when total profit is unchanged. It also implicitly assumes interim distributions are reinvested at the same rate, which is rarely true. For that reason IRR should always be read next to the equity multiple, which is time-blind and cannot be gamed the same way.
Levered IRR includes the effect of debt and is what a limited partner sees. Unlevered IRR strips debt out and describes the asset itself. Quoting one without saying which is a common source of confusion.
How to calculate internal rate of return
0 = Σ [ CFt / (1 + IRR)^t ] for t = 0 to n- CFt:
- Net cash flow in period t, where the initial equity outlay is negative
- t:
- Period index, typically years from acquisition
- n:
- Final period, which includes sale proceeds
Worked example
A five year hold with $2,000,000 of equity invested at close:
- Year 0
- ($2,000,000)
- Years 1 to 4 cash flow
- $120,000 per year
- Year 5 cash flow plus net sale proceeds
- $2,950,000
Rules of thumb
- Never evaluate IRR without the equity multiple beside it. A 30% IRR over 11 months and a 30% IRR over five years are very different outcomes.
- If IRR looks strong but the multiple looks thin, check whether an early refinance is doing the work.
- Sensitivity matters more than the point estimate. Test the exit cap rate and the rent growth assumption before believing any IRR.
Calculate internal rate of return
Related terms
- Equity Multiple
The equity multiple is total cash distributed to investors divided by total equity invested, expressed as a multiple, and it measures how many times an investor gets their money back over the full hold.
- Cash-on-Cash Return
Cash-on-cash return is the annual pre-tax cash flow after debt service divided by the total equity invested, measuring the yearly cash yield an investor actually receives on their money.
- Equity Waterfall
An equity waterfall is the contractual sequence of tiers that determines how a real estate deal's cash flow is split between limited partners and the general partner as return thresholds are met.
- Exit Cap Rate
The exit cap rate is the capitalization rate assumed to apply when a property is sold at the end of the hold period, and it converts projected final-year net operating income into an assumed sale price.