Evaluating Real Estate Investments -- Internal Rate of Return

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Modern Western music notation follows an organized system so musicians can determine the duration of a note. Notes consist of a head (an oval, which also designates the pitch at which the note is to be played), usually a stem that extends vertically from the note, and sometimes one or more flags, which extend from the top of the stem.

A whole note, consisting solely of an open oval, is the longest duration in most music. By adding a stem to a whole note, we get a half note, which lasts half as long as a whole note. By filling in the oval (like a bubble on a test score sheet), we get a quarter note – lasting half as long as a half note or one-fourth as long as a whole note.

Adding one, two, or three flags creates eighth, sixteenth, or thirty-second notes, respectively. Expectedly, an eighth note lasts one-eighth the time as a whole note, and so forth. Successive notes with flags frequent are connected with bars.

When it comes to filling in the head and adding a stem and flags, the more that's added to a note, the shorter it is. But there's more – notes can have dots added next to their head. A single dot indicates a note should last one-and-one-half times as long as the note would be without a dot. Two dots indicate the note will last one and three-fourths as long as the note last would be without a dot.

With some additions shortening a note’s duration and others increasing the duration, a musician must understand and quickly calculate fractions to read music fluently. It can take years before a musician can fluently sight-read music as someone might read a book at sight. And the duration of the note is only one part of reading music. For instance, musicians also must be able to read notation for pitch, articulation, and volume.

As with music notation, methods used to evaluate investment profitability can be confusing and take years to learn fluently, especially when the analysis involves the “time value of money,” such as with internal rate of return (IRR).

This article is part of a series about methods investors use to evaluate investment profitability. A previous article discussed cash on cash return. This article focuses on IRR.

What Is IRR?

IRR looks at the cash outflows and inflows from an investment and calculates an assumed interest rate (discount rate), so the net present value of the cash flows equals zero. For example, for a $1,000,000 investment in a money market account bearing interest at 1% per year, the initial investment would be listed as -$1,000,000 (with a negative sign) since it is an outflow. Each annual interest payment of $10,000 would be a positive value (since it is an inflow). If the investor withdrew their $1,000,000 in principal after three years, that would be listed as a positive number (since it is an inflow).

Most people use the IRR function in Excel to calculate IRR, so they need not know the formula for IRR. The XIRR formula is used when cash flows aren’t paid in consistent periods, such as annually.

IRR differs from a fixed interest rate, which is determined in advance and doesn’t change. When a sponsor advertises a fixed-rate bond, the advertised interest rate is the return the investor will receive. Because IRR calculations are based upon all outflows and inflows from an investment, an investor can compute their actual IRR only after they sell the investment. So, when sponsors advertise a target IRR, it’s a forecasted IRR. The investor’s actual IRR from the investor could be higher or lower if the forecasts used to calculate the IRR differ from actual results.

How Can IRR be Used to Evaluate an Investment?

IRR can be an excellent way to compare dissimilar investments. Consider two $100,000 real estate investments, one of which is expected to produce annual cash flow equal to 2% of the investment and a gain of 10% over the purchase price after a five-year hold period and the second of which is expected to produce 1% in annual cash flow and a 14% gain over the purchase price after seven years. Although one might think that the 14% gain is better than the 10% gain, the first investment is better since it has an IRR of 3.85%, compared to a 2.84% IRR for the second investment.

Real estate investors frequently are presented with IRR forecasts when deciding whether to invest. Consider the following example of how IRR can be used, along with cash flow, to make an investment decision:

Connie and Avery are a retired couple who depend upon their investment income to supplement Social Security. They have $1 million in a long-term certificate of deposit that provides only one percent (1%) of interest or $10,000 in cash per year. With their increased living costs, they need at least $30,000 in cash per year from their investment. Their investment options are to put $1 million in one of the following:

1. Real estate investment in an apartment building forecasting $35,000 in annual cash flow and a 10% IRR based upon an assumed property sale at the end of year seven.

2. An AAA-rated corporate bond that pays 3.5% in interest ($35,000) every year for ten years, with a return of principal at the end of year ten. This investment has an IRR of 3.5%.

3. A real estate investment in an industrial building forecasting $35,000 in annual payments and a 9% IRR based upon an assumed property sale at the end of year five.

4. Investment in a real estate development project taxed as a partnership that forecasts a 17% IRR. This investment is expected to produce tax losses for several years, with all income being reinvested into the project until it is sold in year twelve.

Based solely upon IRR, Investment 4 is the best investment since it produces a 17% IRR, compared to IRRs ranging from 3.5% to 10% for the other investment options.

What IRR Doesn’t Evaluate

IRR can be an excellent way of evaluating the profitability of investments. However, IRR computations disregard factors that may be important when evaluating an investment. IRR doesn’t consider tax benefits (or detriments) from investments, nor does IRR show annual cash flow, default risk, liquidity, or the impact of inflation.

Default Risk

In the example above, Investment 2 is rated AAA, the highest investment rating, translating to low default risk. Most real estate investments aren’t rated. That doesn’t mean that they have a higher default risk than rated investments.

To evaluate a real estate investment’s risk, the investor needs to closely review the investment's financial forecasts to assess default risk and evaluate whether the underlying assumptions are conservative, aggressive, or somewhere in between. Most investors have neither the experience nor interest in doing a deep dive into the forecasts to make this evaluation.

But there is a greater risk that a real estate investment won’t attain its target IRR than that a AAA-rated bond will reach its target. That’s tied both to the inherent risk in real estate investing and to the fact that a target IRR in a real estate is based upon forecasts, which in turn are based upon market and operational assumptions. Since target IRRs are just forecasts, failure to attain them isn’t a default – it just means that the assumptions on which the target was based didn’t come to pass.

On the other hand, the interest rate on an AAA-rated bond is the actual interest rate. If the issuer makes required payments, that’s the amount the investor will receive. Failure to make those payments is a default.

Still, based solely upon the risk of default, Investment 2 is the winner since real estate generally is a higher risk than a corporate bond with a high rating, and an interest rate is akin to a guaranteed return, and a target IRR is not guaranteed.

Tax Ramifications

IRR return doesn’t evaluate the tax benefits (or detriments) of an investment. Suppose Connie and Avery have a combined federal, state, and local income tax bracket of 30%.

Investment 1 is a real estate investment and will produce depreciation deductions to offset some of Connie and Avery's cash return. Suppose 10% of the $1,000,000 investment is assigned to land and 90% is assigned to the apartment building. The land isn't depreciable, and multifamily real estate is depreciated over 27.5 years.

Therefore, Connie and Avery would receive a $32,727.27 depreciation deduction each year, which would reduce their taxable income from the investment. That would save them about $9,818.18 each year in taxes, as they would pay taxes on only $2,272.73 of their cash return for an annual total tax liability of $681.82. However, they would pay taxes on that recaptured depreciation and long-term capital gains tax on the increased value of the real estate when sold unless they can defer their gains through a Section 1031 exchange.

Investment 2 is a corporate bond, so the $35,000 Connie and Avery receive every year would be taxable. They would pay $10,500 on their annual return. However, they would pay no taxes when their principal was returned to them at the end of year ten.

Investment 3 is another real estate investment, so like Investment 1, there would be depreciation. However, because it’s non-residential real estate, the buildings would be depreciated over 22 years.

If 10% of the value is assigned to land, Connie and Avery could take a depreciation deduction of $40,909.09 per year against income of $35,000. Since Connie and Jesse's investment is passive, they would only benefit from $35,000 of their depreciation deduction unless they have other passive income during the tax year. As with Investment 1, they would pay taxes on that recaptured depreciation and long-term capital gains tax on the increased value of the real estate when sold unless they can defer their gains through a Section 1031 exchange.

Investment 4 is expected to produce tax losses at the beginning of the investment. Still, unless Connie and Avery have other passive income, they won’t be able to take advantage of the tax losses. Although Investment 4 isn’t expected to produce cash flow until the sale of the property at the end, Connie and Avery may have to pay taxes on the income that’s reinvested. They will need to find another source of cash to pay those taxes.

Looking solely at tax ramifications, Investment 3 is the winner because it legally shelters more income from taxes, deferring taxes until the end of the investment (when they will be paid at lower tax rates).

Cash Flow

The first three examples all produce the $35,000 Connie and Avery want. But they must use some of the cash they receive from Investments 1 and 2 to pay taxes, so those investments don’t leave them with $35,000 in spending money. Because Investment 3 produces sufficient depreciation deductions to “shelter” the cash flow from income, Connie and Avery will have use of all the cash flow they receive.

Looking solely at cash flow during the investment hold period, Investment 3 is the winner since it provides the most usable cash during the hold period.

Liquidity

Investment 2 is the winner on liquidity. There’s a market where corporate bond investors can sell their bonds for quick cash. Real estate investments are illiquid, meaning they can’t quickly be converted to cash.

In the examples above, Investments 1, 3, and 4 have hold periods of seven, five, and twelve years, respectively, with hold periods being the time the investor’s investment will be illiquid. Longer hold periods are associated with higher IRRs, but if liquidity is important to an investor, the higher IRR might not be worth the loss of liquidity.

Using IRR

IRR is an excellent tool for comparing the profitability of dissimilar investments. However, like deciphering the duration of musical notes, it requires years of experience to become fluent in using IRR. And like the duration of notes is only one of several factors that determine what music is played, IRR is only one of several tools an investor should use when deciding whether to invest.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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