The use of internal rate of return, or IRR, has seen a surge in visibility over the past several years. There is good reason for this. It’s benefits are helpful when comparing the returns of different investments, HOWEVER, there are serious limitations. Title III of the Jumpstart Our Business Startups (JOBS) Act allowed real estate investment companies to crowdfund real estate deals from both accredited and non-accredited investors and use this metric as one of the main selling points of their investment opportunities.
In order to generate revenue, many real estate investment companies committed to short-term real estate deals, usually ranging from three to five years. These deals were marketed as yield-driven, promising both a strong IRR and an average 2.00x equity multiple. IRRs ranged from 15% to 25% or more. Real estate investment companies prioritized growth over long-term value, and investors signed up for what my instincts tell me will be a mistake.
Let me explain.
The IRR is (simply) a projected annual growth rate, and is usually driven up by value-add real estate properties and development projects. Prioritizing IRR as the number one investment criteria leads to fundamentally weak long-term strategies. The focus is directed to numbers, missing the goal of many investors: long-term growth and stability.
As I see it, the IRR has four core weaknesses that investors need to take into account:
- IRR is largely subjective
- IRR calculations are based on arbitrary end dates
- Safety is external to risk in calculations of IRR
- High IRR deals entice investors to sacrifice long-term gains for short-term profits
- #1: The IRR is largely subjective
IRR works best when forecasting projects, with few cash flows, and with short timeframes. The more uncertainty or outside variables in an investment, the less reliable IRR becomes. Such outside variables include management reputation, track record, and corporate transparency. External or unexpected costs are also ignored with standard IRR measures. IRR calculations come with a host of assumptions. Investors often fail to look under the surface to understand how a real estate investment company calculated the IRR. Forecasting needs to be treated with some degree of skepticism.
#2: IRR calculations are based on arbitrary end dates
IRR is the rate of growth a project expects to generate over a certain amount of time. Projects often establish an arbitrary end date of from three to ten years, and peg the IRR and other return calculations to the chosen end date. Unfortunately, many projects fail don’t assume potential downturns in the market, making the initial IRR calculation virtually worthless. External factors may drive project managers to sell early or extend beyond the initial timeframe
#3: Safety is external to risk calculations within the IRR
The IRR excludes are external factors affecting growth – this explains why ‘internal’ is used as the I in IRR. The calculation for the IRR is based on net cash flow, total investment, the net present value of cash flows, and the number of time periods. IRR says nothing about external factors that also affect an investment decision. A true long-term investment strategy is able to manage a rash of external factors that heavily influence profitability: interest rates, inflation, human behavior, political changes, legal rulings, and economic boom and bust cycles. Safe, stable investing is external to the IRR.
#4: High IRR deals entice investors to sacrifice long-term gains for short-term profits
IRR deals north of 25% or 30% effectively blind investors to the ability to think long-term. Many crowdfunded deals are for three to five years with outstanding IRRs. But are these the best investments to build long-term wealth? I am convinced IRR is one component that drives investors to chase short-term profit. Such investors sacrifice the stability and value to owning and holding real estate over the long-term: 15 to 20 years or more. 12% IRR on a 15- to 20-year deal implies more stability, growth, and potential than 30% IRR on a 3-year deal. Short-term deals will also suffer transaction costs and the need to continually reinvest in additional high IRR deals. This is not a winning strategy for safety and stability.
IRR may have a place in investment analysis and strategy, but it needs to be taken with caution.