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An REFM customer asks three terrific questions about IRR.
What’s a good IRR? In other words, at what IRR is an investment worthwhile?
As we teach in our REFM tutorial on internal rate of return, we like to describe the IRR as the average annual return on the cash investment up through the point at which the IRR is measured. So, assuming the IRR in question is that measured as of the end of the investment timeline, a “good” IRR is one that you feel reflects a sufficient risk-adjusted return on your cash investment given the nature of the investment. But remember to keep in mind that the IRR’s calculation (which is annual by its mathematical nature) is biased by the investment timeline and the timing of cash flows within that timeline.
In terms of “real numbers”, I would say (with very broad brush strokes), on a levered basis, here are worthwhile IRRs for various investment types:
- Acquisition of stabilized asset – 10% IRR
- Acquisition and repositioning of ailing asset – 15% IRR
- Development in established area – 20% IRR
- Development in unproven area – 35% IRR
The caveat to these approximations is that your perception of the risk of each of these investments is likely not perfectly calibrated with mine or that of anyone else. So at the end of the day, it’s a subjective determination. This is a perfect segue to your second question.
With which other number/indicators should we compare the IRR?
The IRR does not tell us everything about the investment. For instance, it doesn’t tell us the length of the investment or how risky it is. Always consider the IRR in concert with:
- the going in (calculated) and going out (assumed) cap rates
- the NPV (which requires selection of an internal discount rate) as of the end of the investment timeline
- the multiple on equity (how many times you get your cash investment back as of the end of the investment timeline)
As an example, if the IRR is very high, it could be partially the result of a compressed investment timeline (let’s say you flip a house in under a year). But you may only make $10,000 in pre-income tax profit on a $80,000 cash investment. So the relatively low multiple on equity of 1.125x would help keep you “sober” when evaluating your desire to execute on the investment opportunity.
If the IRR is higher than the discount rate it means that the investment will not be losing money, but on average how much greater should the IRR be in order to count as an attractive investment?
A very tough question to answer. I would say high enough to get you to engage in that particular investment as opposed to pursuing one of the other opportunities you have into which you could deploy the capital in question.
Any thoughts from the readers?
I like the last question and answer. Sometimes there not many choice on investments so we tend to pick the one by default. That can lead to a low return and higher risk. Sometimes it may be better to pass and wait for a better opportunity if time allows.
Hi, thank you for your reply! I tried to answer the best I could; would be a good interview question to see how the candidate thinks.
The generalized numbers you present are not that different from 20 years ago in a world of vastly different interest rate structures. How would you compare real estate returns (development in an established area, acquisition and repositioning) to other investment vehicles? Can you show how realistic a 20% IRR in a world of low interest rates? Another measure I have seen used is the return on cost. This would be the rental income as a ratio to total project costs. This is then compared to financing rates/costs. Ratios greater than financing rates provide positive leverage and a 200 point spread over financing yields returns near your examples.
Hi Lowell, thank you for the reply, which provides great context. Unfortunately, you can back solve for any level of return when financial modeling, and people only brag about their wins at cocktail parties (and tend to round up when doing so), so who knows what most people are really achieving!
As is said “Figures never lie but iiars always figure”!! LOL!