What is the Internal Rate of Return?
This article is not intended to be a recital of academic articles of which there are many on the internet. This is intended as a practical guide to use IRR in the everyday office workplace, particularly, in the Commercial Real Estate investment management industry.
The Theory
The IRR, the Internal Rate of Return, is the discount rate that achieves a Present Value of zero for a given investment cash flow.
E.g. if we invest $1,000,000 today and get $1,100,000 in a year’s time, the IRR that provides a Present Value of zero for the proposed investment is 10%.
Running through the above example mathematically is straightforward:
To calculate a Present Value (‘PV’) of zero, you take the initial investment of $1,000,000 spent on Day-1 LESS the amount of, say, a £1,100,000 at sale after Year 1 and discount it by 10% (£1,100,000 / (1+10%)) which equals £1MM LESS £1MM = 0. In other words, the total expected future amounts equate to the value of our money today (£1 million) at a discount rate of 10%. Since ‘PV’ = 0, the IRR is by definition 10% for this investment scenario.
The IRR discussion in the Workplace
But the academic and mathematical description is not helpful during the hectic days of deal-making and catch-ups with investment colleagues, or indeed nuanced discussion at Investment Committee when approving a new investment opportunity. So how is it referred to in practice?
The biggest mistake…is to use IRR exclusively.
Harvard Business Review, March 17, 2016 ‘A Refresher on Internal Rate of Return’
A more common way to think about the IRR is that it’s an indicator of how fast an investment makes money. As the above ‘time value of money’ theory emphasises the classic business phrase ‘my time is money’ then, everything else being equal, the higher the value of the IRR, the better the proposed scenario for the investor. It is a truism that $100 in the hand today is worth more than receiving $100 in a year’s time – and today’s rising inflation is reminding everyone of the real impact of this theoretical and practical reality.
The IRR does not suffice in isolation
The IRR is exceptionally important in the Commercial Real Estate fund management industry. It is a universal and global benchmark of success against which all funds can be compared against to understand their track records. When an investment team raises a new fund they are undoubtedly questioned about what IRRs have been achieved by their vintage (read ‘prior’) funds.
But like the speedometer in F1 driving, speed is not everything. There is no point hitting a record speed if your F1 driver, team and vehicle cannot endure the necessary laps to complete the race.
The Equity Multiple complements the IRR
This is why there are two metrics of ultra-importance for investment professionals: The IRR and the Equity Multiple. You could think of them as the essentials of speed and distance in F1 racing. How fast do I cover ground? And how much ground do I cover? i.e. How fast does an investment make money? And how much actual money does this investment make expressed as an Equity Multiple?
Equity Multiple is generally expressed in the following format: “0.00x”. Firms tend to report Equity Multiple by, for example, stating 2.00x (“a two times equity multiple”) to indicate that an investor has doubled their money during the course of the investment. E.g. $2 MM has been returned to investors following an initial $1MM investment.
IRR and Equity Multiple issues
Generally speaking, there is an inverse relationship between IRR and Equity Multiple over time. IRRs tends to diminish over time while the Equity Multiple increases. The smartest fund managers assemble the appropriate portfolio of assets to target a blended IRR and Equity Multiple their fund has offered/’promised’ to their investors.
We’ll explore this dynamic in a subsequent post.