What is IRR in Passive Real Estate syndication?

The IRR is a crucial term for real estate investors, but also one of the most complex to understand. As a passive investor, it’s important to expand your investing vocabulary and get a handle on terms like cap rate, capital stack, NOI, and ROI. However, when it comes to IRR, many investors find themselves struggling to understand its importance. The reason is simple: time, or rather, the time value of money.

While cap rate may be the most popular metric for evaluating an apartment building, IRR is often the most important measuring stick for many investors when assessing an investment opportunity. In this article, you will learn all about IRR, how it differs from ROI, how to calculate it when evaluating a deal, and why it’s essential to pay attention to this metric.

Although the internal rate of return (IRR) is a financial metric that helps estimate the potential profitability of investments, its definition might make it seem similar to average or total returns.

Time is The Key Ingredient When it Comes to IRR.

When it comes to investing in real estate, one of the most important metrics to understand is the internal rate of return (IRR). While it may sound similar to other metrics like average annual return or total return, what sets IRR apart is its consideration of time. It is used to estimate the profitability of potential investments by factoring in the length of time involved in the calculation.

In comparison, return on investment (ROI) does not consider how long it will take to collect your returns. This makes IRR a standard metric for comparing investment returns. For investors looking to evaluate commercial real estate investments, it is crucial to have both IRR and another metric like the equity multiple to make an informed decision.

For example, if you invested $100k in a real estate syndicate and earned a profit of $300k plus your principal, your equity multiple would be 4x. However, if it took 40 years to make that 300% return, a high equity multiple doesn’t mean much. This is where IRR comes in – it considers the time factor and can provide a more accurate assessment of the investment’s profitability.

In general, a solid return over a short period of time, such as three to five years, will result in a high IRR and an excellent investment. This is why real estate syndication deals that go full cycle in two years often have sky-high IRRs. When evaluating the velocity of capital, time plays a significant role, and IRR becomes the most important metric to consider.

In summary, IRR is a crucial metric for real estate investors to understand as it accounts for the time value of money. By factoring in the length of time involved in an investment calculation, IRR can provide a more accurate assessment of the investment’s profitability than other metrics like ROI or the equity multiple.

Once more, I can present you with the complex equation I found on Investopedia:

To explain IRR, we can say that it is a rate that discounts future cash flows in a way that the sum of their present values equals zero. In other words, it is the discount rate at which the net present value (NPV) of an investment becomes zero when calculated using discounted cash flow analysis.

In comparing different investment opportunities, it is important to consider the length of time your capital will be invested. Cash flows generated over a shorter hold time typically result in a higher IRR, while those over a longer hold time generally result in a lower IRR. Therefore, it is more effective to use IRR instead of ROI when evaluating investments with varying hold periods.

Passive investors should not rely on ROI alone to compare investment opportunities that differ in hold periods. Instead, they should use IRR to accurately gauge potential returns while factoring in the length of time their capital will be tied up. This is because the time value of money is significant, as noted by Ben Franklin, who famously said, “Time is money.”

Keeping It As Simple As Possible

Comparing investment deals with different lengths, classes, and types would be challenging without a clear understanding of the IRR for each deal. Fortunately, deal sponsors, such as Fortress Federation, provide IRR and other relevant information to help investors understand the sensitivity of the deal’s analysis in the offering memorandum. While it is not necessary to calculate the IRR, investors can learn the formula and use online calculators or spreadsheets for a more detailed analysis.

One critical aspect to keep in mind is that the frequency of distributions paid to investors, combined with a shorter holding period, can increase the IRR. For example, monthly distributions (rather than quarterly) and early sales are popular methods to boost the IRR. Achieving a higher IRR by doubling your investment in three years instead of five is an attractive proposition for any investor.

In short, understanding the IRR is crucial when evaluating investment opportunities as it takes into account the time factor and helps compare deals with different lengths, classes, and types. By considering the sensitivity of the analysis, investors can make more informed decisions, and while IRR calculations can be complex, they are readily available to investors through deal sponsors or online calculators. Ultimately, investments with higher IRR, achieved through shorter holding periods and frequent distributions, are more attractive to investors seeking to maximize their returns.

It Isn’t Only Time That Affects IRR.

The IRR provided in the executive summary of a real estate deal is usually based on the entrance cap rate, which is subject to change. As the cap rate changes, the IRR also changes. Therefore, it is crucial to review the sensitivity analysis, which typically includes a chart that shows how various factors, including changes in the cap rate, can affect the IRR. This chart helps investors understand the potential risks and rewards associated with the investment and make informed decisions.

The expected IRR of a syndication investment is heavily influenced by the asset class and strategy used. Even if two apartment complexes are located in the same metropolitan area, they can have vastly different appreciation strategies and classes. For instance, a stabilized A-class apartment syndication may have a term of seven years with no refinance opportunity and an IRR of 13%-15%. On the other hand, a B-class value-add multifamily syndication may have a five-year business plan, a refi opportunity, and forced appreciation from the renovations, pushing the IRR up to 14%-17%.

Increasing income streams, improving operational efficiencies, and getting units to market rents are all factors that can impact the IRR in underwriting. By implementing things like laundry services, mail delivery lockboxes, new property management, and payment software for tenants, the experience for tenants can be significantly improved, supporting higher rent rates. Moreover, overall property upgrades that come with generally low costs can lead to an increase in demand and higher rental rates, bumping up the NOI and positively impacting the IRR.

Overall, to compare syndication investments, it is crucial to take into account the asset class and strategy, as well as the underwriting approach that is being used to drive returns. This information can help investors to make informed decisions about which investment opportunities are right for them, and which are most likely to offer the best returns over the long term.

Alignment of Interests

When evaluating potential syndication deals, it’s important to consider how they align with your investment strategy. You should start by considering the types of syndications you’re interested in and the exit strategy that works best for you. For example, if you’re looking for a long-term hold with high cash-on-cash returns, you may not be interested in a short-term renovation with a refinance and return of capital.

Return hurdles, also known as waterfall structures, are another area where IRR comes into play. It’s essential to examine the private placement memorandum and operating agreement closely to ensure that the deal structure and business plan align with your strategy. If the deal hits a specific IRR, the profit split or equity split may change.

Metrics vary widely between asset types, classes, and markets, so it’s important to weigh the pros and cons of each. You should consider the growth trends in the market and whether you’re comfortable locking your investment capital in for several years.

The operator’s track record is also a crucial factor to consider. Look into their philosophy and the way they run their business to determine if you agree with their approach. It’s also important to trust the operator and feel comfortable with their investment decisions. Fortress Federation, for example, places a high priority on capital preservation, followed by monthly distributions and appreciation.

In addition to IRR, other metrics like the average annual return or equity multiple may seem more straightforward. However, these metrics don’t factor in time the way IRR does. Therefore, it’s crucial to give IRR the attention it deserves.

Finally, when evaluating a syndication deal, you should consider the breakeven occupancy rate, expense ratio, deal structure, and loan or debt details. Deals with a low breakeven occupancy rate and expense ratio are more likely to meet projections. Deal structures can vary widely, so it’s essential to carefully examine preferred return percentages and distribution splits. Loans on the property may also include a wide range of rates, terms, and options.

Ultimately, your selection should align with your values and investment goals and be within your risk tolerance. If you ever have any questions or want to discuss potential deals further, don’t hesitate to reach out for a chat.

By becoming a member of the onbridge Capital Investor Club, you can enjoy the advantages of investing in real estate without the difficulties and burdens associated with being a landlord.

By providing your details below, you can sign up to receive a free QuickStart Guide that will help you get started with investing in syndications.