Internal rate of return (IRR) vs. annual rate of return: what’s the difference between them? Which one’s more useful?
In the commercial real estate (CRE) investing space, accredited investors are constantly seeking out new opportunities in up-and-coming real estate markets. As investors diversify into real estate, it’s critical they find the most appropriate risk/return profile for their particular strategy. This involves being able to grasp how investment returns are measured.
Two fundamental metrics that investors often encounter are the internal rate of return (IRR) and the annual rate of return. Both metrics play a role in indicating investment performance, but they are not the same thing—they differ significantly in how they are calculated and the insights they render. This article dives into what those differences are in order to provide useful context for investment decisions.
This article will also take a look at how self-directed investors should consider IRR vs. annual rate of return while vetting investment opportunities on platforms such as EquityMultiple.
Understanding the Basics: IRR and Annual Rate of Return
To lay the groundwork, let’s first deepen our understanding of these two metrics:
- The annual rate of return presents a straightforward measure of an investment’s growth over a specified period, expressed as a percentage. It simplifies the return on investment to an average yearly figure, which is relatively easy to calculate and comprehend.
- On the other hand, the internal rate of return (IRR) is a more intricate calculation incorporating the “time value of money.” It signifies the discount rate at which the net present value (NPV) of all cash flows (both incoming and outgoing) from a particular investment equals zero. Does that sound complicated? Don’t worry, we’ll expand upon the time value of money very shortly.
IRR offers a very comprehensive view of an investment’s profitability over time because it takes into account the timing of each cash flow.
Example of IRR vs. Annual Rate of Return
Let’s say you’re investing in real estate with $10K as an initial investment and three years of expected cash flows. If the project returns $2K annually, the simple annual rate of return calculates to 20%. However, if these cash flows occur at varying times and amounts throughout the investment period, the IRR would provide a more accurate measure of the investment’s annual growth rate because it factors in the time value of money. This distinction is crucial for investors, as it can significantly impact the perceived profitability of an investment.
Diving Deeper: The Significance of Time Value of Money
As we’ve already stated, the time value of money is a fundamental principle in finance that is central to understanding why IRR offers a distinct perspective versus the annual rate of return. The principle acknowledges that a dollar today is worth more than a dollar in the future due to its potential earning capacity. This core concept is what makes the IRR calculation critical for investments with varied cash flow timings, such as many commercial real estate projects.
To illustrate, let’s consider a hypothetical example in which an investor evaluates two potential real estate investments. Investment A expects to deliver a lump sum return in five years, whereas Investment B provides incremental returns over the same period. Although both might have the same annual rate of return, Investment B could have a higher IRR, reflecting the benefit of receiving cash flows earlier, which could subsequently be reinvested to generate additional income.
| Scenario | Initial Investment | Year 1 Cash Flow | Year 2 Cash Flow | Year 3 Cash Flow | IRR |
|---|---|---|---|---|---|
| Base Case | -$100,000 | $40,000 | $50,000 | $60,000 | 21.6% |
| Higher Early Cash Flows | -$100,000 | $60,000 | $50,000 | $40,000 | 25.3% |
| Lower Early Cash Flows | -$100,000 | $20,000 | $50,000 | $80,000 | 18.8% |
| Back-End Cash Flows | -$100,000 | $0 | $0 | $150,000 | 14.5% |
| Larger Investment | -$150,000 | $60,000 | $75,000 | $90,000 | 21.6% |
| Smaller Investment | -$50,000 | $20,000 | $25,000 | $30,000 | 21.6% |
| Negative Cash Flow | -$100,000 | -$20,000 | $50,000 | $120,000 | 14.7% |
The table above considers several similar IRR scenarios in order to demonstrate the time value of money’s impact on an IRR calculation.
IRR vs. Annual Rate of Return: Which One Should I Use?
The choice between the IRR and annual rate of return hinges on the nature of the investment and the investor’s objectives. For investments yielding uniform annual returns, the annual rate of return offers a clear and straightforward measure of profitability. However, for more complex investments, particularly those with irregular cash flows over time, the IRR is likely the preferable metric.
In the context of commercial real estate (CRE) investing, where cash flows can vary significantly over the investment period, the IRR provides a more accurate reflection of an investment’s performance. It enables investors to compare the profitability of different investments on a level playing field, regardless of their cash flow timings.
Case Study: Real Estate Investment Analysis
To further elucidate, let’s examine a case study of a multifamily property investment requiring an initial investment of $2 million, with projected cash flows from rent and eventual sale totaling $3 million over the course of seven years. While the annual rate of return might suggest a straightforward profitability metric, the IRR calculation, which accounted for the varying annual cash flows and the final sale, revealed an annualized return rate of 12%. This nuanced understanding allowed the investor to directly compare this opportunity against other potential investments with different cash flow profiles. Thus, IRRs may provide superior insight in complex investment scenarios.
Integrating the IRR into Real Estate Investment Strategies
For accredited investors exploring commercial real estate opportunities, especially passive investors, understanding the IRR is crucial. It aids in evaluating individual investments and in crafting a diversified investment portfolio that aligns with one’s financial goals and risk tolerance. By incorporating the IRR into investment analysis, investors can identify opportunities that offer the best potential for growth, considering the time value of money. This approach facilitates a deeper understanding of how different investment structures, such as debt versus equity, can impact returns over time.
As you evaluate investments, it’s important to look not just at the IRR figure, but at the projected cash-flows and assumptions that contribute to that IRR figure. How long will it take to deliver the target return? What type of cash flow (if any) may be delivered during the term of the investment? What are the risk factors — both in terms of cash flow and executing on the overall business plan to deliver the target IRR?
IRRs at EquityMultiple
EquityMultiple, an alternative investment platform specializing in commercial real estate (CRE), categorizes its offerings in three ‘pillars’—Keep, Earn, and Grow. True to their name, Grow investments are growth-focused (as opposed to Keep and Earn, which aim for yield and near-term income, respectively). Grow investments are the only investments on the EquityMultiple platform to use IRRs when measuring returns. This is because Grow offerings typically target mid-term cash flows, as opposed to the typically fixed, regular cash flows of offerings in the Keep and Earn pillars.
If you have any questions about IRRs or annual rates of return as they pertain to investments on the EquityMultiple platform, don’t hesitate to connect with our Investor Relations team.
For any Grow investment, you can find the IRR near the top of each offering page:
You can also find details about how the IRR and other return metrics are projected within the body of the offering page, and in more detail in the offering’s Investor Packet, along with risk factors and disclosures.
The Bottom Line
Make no mistake: both the IRR and the annual rate of return are essential tools for measuring investment performance, but one may be more useful than the other depending on the type of investment under consideration. While the annual rate of return is well-suited to investments with very simple and unvarying cash flows, the IRR also accounts for the time value of money, making it the more appropriate choice for evaluating complex investment structures. As investors equip themselves with a deeper understanding of these metrics, they will feel more empowered to make sophisticated investment decisions. Ultimately, they may benefit from the diversification advantages of real estate investments in a portfolio already allocated to stocks and bonds.
IRR vs. Annual Rate of Return FAQs
Q: What is the main difference between IRR and annual rate of return?
A: The main difference lies in their calculation and what they measure. The annual rate of return calculates an investment’s growth as an average yearly percentage, while IRR considers the time value of money to provide the discount rate at which the net present value of all cash flows equals zero.
Q: Why is the time value of money important in investment analysis?
A: The time value of money is crucial because it recognizes that money available now is worth more than the same amount in the future due to its potential earning capacity. This principle is essential for accurately assessing the profitability of investments with cash flows spread over time.
Q: Can I use both IRR and annual rate of return to evaluate an investment?
A: Yes, using both metrics can provide a comprehensive view of an investment’s performance. The annual rate of return offers a straightforward measure of growth, while IRR provides deeper insights into the investment’s profitability over time, considering the timing of cash flows.
Q: How does EquityMultiple incorporate IRR in its investment offerings?
A: As a leading real estate investment platform, EquityMultiple provides detailed financial projections, which frequently include IRRs, for each of its commercial real estate investment offerings. This allows accredited investors to assess the potential returns of different investments, considering the complex cash flow structures typical in real estate projects.
Q: Is IRR always a better metric than annual rate of return?
A: Not necessarily. The choice between IRR and annual rate of return depends on the investment’s nature and the investor’s goals. IRR is particularly useful for investments with irregular cash flows, while the annual rate of return may suffice for simpler investments with uniform returns.
