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The Importance, Limitations And Concept Of ‘Quality’ Of IRR

By News Creatives Authors , in Real Estate , at September 29, 2021

Managing Partner, Capital Markets at PIA Residential.

As a real estate private equity firm operating in the multifamily acquisition space, my company receives an abundance of feedback and questions regarding our predictive financial modeling. One of the most prevalent questions is regarding the returns. We are often told by investors that they “see opportunities with a much higher IRR”; however, they often fail to accurately compare each opportunity that is presented to them. At PIA, we believe it is paramount to provide our investors guidance and education on the proper ways to assess risk accurately.

Sponsors can willingly or accidentally manipulate return profiles to show inflated numbers. Assumptions are the backbone of the predicted returns and can lead to skewed projections. Unnecessary risk is assumed if there is poor understanding of the limitations and frequently used tactics associated with potentially inflated figures. 

Unfortunately, responsible sponsors who make conservative assumptions to decrease the risk carried by their limited partners are often at a disadvantage when presenting their return profiles. To continuously attract capital and interest from the investor’s base, sponsors must exhibit honesty and integrity, and build trust by avoiding unnecessary risk and exceeding or living up to the original projections. Although the IRR does a fantastic job of showing the time value of the invested capital, it does not provide a complete view of the potential risk, unless combined with other metrics that allow opportunities to be pressure-tested to mitigate as much risk as possible. 

Through an informal survey of 20-plus investors, we found that the great majority do not understand the concept of IRR and how the metric can be “manipulated.” Savvy investors must learn to utilize several metrics to feel confident in their due diligence and understand the risk associated with each investment opportunity. After coming to this realization, we created the term “quality of IRR,” which basically splits the IRR into two components. One is the cash-on-cash generated by operations, and the other is the return derived from the sale event at the end of the investment period. It also analyzes the impact on risk and returns from events such as refinancing.

Essential Return Metrics To Combine With IRR And Their Limitations

As discussed in a previous article, real estate return metrics have unique limitations. Combined, they provide a clearer view of the risk in investment opportunities. Below I’ll highlight several alternative metrics and their respective limitations:

1. Cash-on-cash: “a rate of return often used in real estate transactions that calculates the cash income earned on the cash invested in a property.”

Limitation: averages cash yields over the assets hold period. Cash flow can vary wildly from year to year, and investors should analyze when they receive these distributions in the hold period. 

2. Equity multiple: “the total cash distributions received from an investment, divided by the total equity invested.”

Limitation: provides a snapshot of overall profitability; however, it doesn’t consider the time value of money, the length of time the investor’s money is tied up or the cash flow distribution throughout the project’s lifetime.

3. Cap rate: calculated by dividing a property’s net operating income by the current market value.

Limitation: The integrity of a cap rate is built upon the forward-thinking data set used in deriving NOI; with prognostications, there is a tremendous weight put on the assumptions the manager makes.

Limitations Of IRR

Individually, IRR has shortcomings that investors and managers would be remiss in ignoring. Below are a few examples of areas in which IRR falls short:  

• The initial investment amount between investment alternatives is not considered.

• It ignores the actual dollar value of comparable investments.

• It does not compare the holding periods of like investments.

• It does not account for eliminating negative cash flows.

• It provides no consideration for the reinvestment of positive cash flows.

Financial Engineering And Potential Manipulation Of IRR

When considering equity investment opportunities, you must understand the risks of potential financial engineering — where the utilization of leverage and ambiguous data could be used to increase the bottom line. The IRR metric is certainly a target risking the quality of IRR. Here are several ways IRR can be engineered to consider:

• High leverage can also be a sign of engineering; if the LTV is higher than 80%, there isn’t much room for the business plan to underperform without sinking IRR.

• Analyze the hold period and lockout periods for the sale of an asset. When the time horizon is minimal, it is much easier to show an inflated IRR.

• Be wary of investment managers who plan to refinance and solely pay the management team. If a refinance occurs, both the manager and the investor should benefit — look for lockout periods on refinancing.

Quality Of IRR: Critical Thinking And Understanding Risk

The focus on evaluating and choosing investment opportunities is aligning your risk tolerance with that of the sponsor. The need for prospective investors and managers to consider the quality of IRR and examine whether the profits justify the risk level is clear. We urge you to combine IRR with other real estate metrics, pursue transparency and realize the quest for risk-adjusted “after fee” returns.

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