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How IRR Can Mislead Investors

How IRR Can Mislead Investors

The internal rate of return, or IRR, is widely used in real estate because there’s no straightforward way to check a property’s actual or potential performance. This is unlike investments in stocks, which one can easily check by calling one’s broker or by going online. But IRR is not a perfect tool. Far from it, in fact, IRR can mislead you.

After all, its calculations use assumptions and do not consider variables that are outside an investor’s control. Those variables can include drops in rental rates or, say, unknown damages. Also, some investors make investment decisions by comparing IRR to annual returns, which is not a good idea.

For all of IRR’s value as a measuring stick, here’s how IRR can mislead investors – and more.

What is IRR?

Let’s start there. The internal rate of return calculates and anticipates project performance. The metric, which is expressed as a percentage, gives investors a good idea of the average annual return they have or can expect to realize over time.

But as we say, the IRR does have limitations.

Annualized Returns and IRR

To make wiser real estate investment calls, it’s vital that investors understand the difference between IRR and an annualized return. This is the sum of cash investors make or expect to make, each year on their investments.

For instance, after factoring in compounding, a $1 million investment that generates an annualized return of 8 percent will be at around $10 million in 30 years. Compounding capital over time is the source of real wealth. For example, a 10 percent annualized return doesn’t sound all that exciting. That is until you realize that the 10 percent doubles every seven years. Thus, in 21 years, an investment that produces a 10 percent annualized return will be worth eight times more.

By contrast, the internal rate of return aims to provide an equal annualized return rate. However, it considers the timing of cash flows, whether the money is invested for short periods (days or weeks) or not. Moreover, because IRR assumes the immediate reinvestment of distributions, there’s an inherent compounding assumption that doesn’t hold up.

A Big Problem with IRR

With IRR, it’s hard to know in real dollars how much profit you have. That’s because it’s unknowable how much a $1 million investment, which has an IRR of 8 percent over 30 years, is worth today. That can make it challenging to know whether to sign off on a project.

After all, $100 today is not worth the same as 20 years ago, nor will it be worth the same 20 years from now. Thus, cash flows that occur far into the future generally carry more risk than those that happen earlier.

Similar, But Not Really

The fact is that while the internal rate of return and annualized returns may seem the same. However, they really are not. It’s generally not a good idea for investors to go after lofty IRRs in short durations. In other words, a high IRR may not actually generate any real profits.

Now that you know how IRR can mislead investors, you can still use the tool. Just be careful to understand its limitations. After all, there are few other viable alternatives available. Thus, why the metric is still the most common to use. Just ensure your expectations are realistic.

Whether you’re new to real estate investing or just want to fortify your knowledge base, the alternative investment platform Yieldstreet has resources that can help you with learning how IRR can mislead and how to benefit.

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