IRR in Real Estate
It’s important to note that the IRR should not be the only metric that sways your decision when evaluating real estate investments like a multifamily property. Regarding return expectations, IRR returns in many real estate investment asset classes are usually in the teens. Many real estate investors confuse this with cash-on-cash returns or average annual returns (AAR). AAR considers the average rate of return that you’ll get over the hold of however many years the project is held. The IRR percentage does not necessarily quantify that actual dollar amount based on the IRR percentages as the ARR would.
Just because a project has a higher IRR or higher cash flows doesn’t necessarily mean it’s the standout better investment. You’ll recoup your invested dollars sooner, but you could still achieve a higher return or multiple on your equity in another deal with a lower IRR projection.
Target Equity Multiple (TEM)
The targeted equity multiple (TEM) is another metric that investors use to measure the attractiveness of a potential real estate investment. The TEM calculation looks at how much cash flow is generated in relation to the amount of invested equity. The targeted equity multiple is essential because it gives investors a sense of their overall return on their invested dollars if they hold the investment for a certain period of time.
What is a good IRR in Real Estate?
A good IRR in real estate investing could be somewhere between 15% to 20%. However, it varies based on the cost basis, the market, the particular class, the investment strategy, and many other variables.
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What is an acceptable IRR in Real Estate Investing?
IRR expectations are not equal; the IRR and other return metrics are closely tied to the property’s risk profile. An excellent acceptable IRR for a multifamily deal ranges from 12% to 15%.
IRR definition in real estate
The IRR is the rate needed to convert the sum of all future uneven cash flows (cash flow, sales proceeds, and principal paydown) to equal the equity investment. IRR is one of the main factors passive investors should focus on when qualifying a deal.
A Simpler Example;Let’s say that you invest $50. The investment has cash distributions of $5 in year one and $20 in year 2. The investment is liquidated at the end of year 2, and the $50 is returned. The total profit is $25 ($5 year 1 + $20 year 2). The simple division would say that the return is 50% ($25/50). But since the time value of money (two years in this example) impacts return, the IRR is only 23.43%.
If we had received the $25 cash flow and $50 investment returned all in year 1, then yes, the IRR would be 50%. However because we had to “spread” the cash flow over two years, the return percentage is negatively impacted. The timing of when cash flow is received significantly and directly impacts the calculated return. In other words, the sooner you receive the cash, the higher the IRR will be.
What is a good equity multiple?
Equity multiples range from project to project; if you can get a 2X equity multiple, that’s a solid investment. That means you made two times what you initially contributed to the deal.
Finding a dependable risk-adjusted investment vehicle that enables you to safely double your money every 5-7 years should be the goal. Here at Willowdale Equity, we focus on multifamily real estate as an asset class that can provide those mentioned above, plus all the tax advantages and much more. This type of investment vehicle is referred to as a real estate syndication, where investors pool their money together to purchase more significant assets than they would be able to as an individual.
Difference between equity multiple and IRR.
The equity multiple is the total amount of cash for equity investment in a company over time. The IRR function calculates the proportion of profit on any investable dollar generated during an annual investing period.
A property with a high IRR may quickly increase income for an investor, but a higher return to investors may not necessarily accompany it. The internal rate of return isn’t factored into the equity multiple calculations.
The IRR and Equity Multiple are shown in tandem because one metric tells investors a story that the other metric leaves out. In this scenario, the IRR calculation accounts for the time value of money (TVM), whereas the Equity Multiple does not.
IRR In Real Estate - Conclusion
It’s more advantageous to receive cash distributions and a return sooner on your hard-earned dollars than to receive it later when your real estate is investing. But don’t let IRR or net present value cloud your analysis, and it is the only metric you use to evaluate an investment opportunity. It’s also important to note that even if the deal you’re invested in has a “lower cap rate,”all the projected returns can still be hit. This is due to the ability to use leverage (debt), which lowers the amount of total cash needed for the deal and increases our overall cash returns.
Many industry experts get caught up in comparing return metrics like AAR vs. IRR, equity multiple vs. IRR, or cash-on-cash return vs. IRR to find the ultimate return metric to follow.
But, as investors, we should be using all the return metrics like COC and AAR and what the equity multiple will be on your cash over the hold period of the deal. The name of the game when it comes to real estate investment opportunities, especially in an asset class like multifamily real estate, is tomultiply your capital and continue to compound it.
You don’t need investment advisory services to tell you that, so make sure you use all the tools in your toolbox before you strike your next deal.
Courtesy: Daniel Di Cerbo
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