The internal rate of return (IRR), expressed as a percent, is the return that each dollar in an investment earns while it is in that investment. Appraisers often refer to IRR as a discount rate while investors often use the term yield.
The cash flow model, used to calculate IRR, takes into account multiple factors including changes in cash flows and the impacts of leverage and tax benefits, thereby providing a more comprehensive picture of an investment’s profitability than the direct capitalization method (cap rates). It is not without its limitations though. Because IRR only measures the dollars in an investment while they are in that investment it does not account for external factors that can affect the dollars that are taken out of the investment.
Here are the pros and cons of using IRR to measure investment performance:
Pros
- Because it uses the cash flow model, IRR answers the 4 basic questions governing any investment decision:
- How many dollars go into the investment?
- When do the dollars go in?
- How many dollars come out of the investment?
- When do the dollars come out?
- Measures impact of financial leverage – Many real estate investments are purchased with debt financing, not only because the buyer may not have the funds to pay in cash but because of the ability to increase one’s return through positive leverage. If the cost of funds is less than the unleveraged yield the IRR will increase as a result of financing.
- Measure impact of tax benefits – There are many tax benefits associated with real estate ownership that lower an owner’s taxable income and effective tax rate, thus resulting in an increase in IRR.
Cons
- Does not adjust each investment alternative to eliminate negative cash flows
- Does not consider the reinvestment of positive cashflows
- Does not adjust for size disparity between initial investment amounts between investment alternatives
- Does not adjust for time disparity between holding periods between alternative investments
The cons associated with IRR are addressed by a process called capital accumulation.