Internal rate of return
Also called IRR.
The internal rate of return is the discount rate at which the net present value of a deal's cash flows equals zero. It expresses a full investment, including the timing of every contribution and distribution, as a single annualised percentage.
How it works
IRR is the standard return measure in real estate private equity because it handles the two things simpler measures cannot: irregular cash flows and time. A deal that returns capital early is genuinely better than one that returns the same capital later, and IRR is the measure that says so.
It also has real limitations that get glossed over. IRR implicitly assumes interim distributions are reinvested at the IRR itself, which is rarely true and flatters short, high-return deals. It can be undefined or multiply defined when the sign of the cash flow stream changes more than once, which happens whenever a deal has a capital call after distributions have begun. And it says nothing about scale: a 30 percent IRR on $500,000 of equity and a 15 percent IRR on $20 million are not comparable propositions.
For those reasons IRR is always read next to equity multiple. The pair is the standard because each one covers the other's blind spot: IRR measures speed, multiple measures magnitude, and a deal has to be evaluated on both.
Formula
IRR is the rate r where the sum of each cash flow divided by (1 + r) raised to its period equals zero- Period zero is the initial equity contribution, entered as a negative number
- There is no closed-form solution, so it is found by iteration
- Levered IRR uses cash flow after debt service; unlevered IRR uses property-level cash flow with no debt
Worked example
Illustrative. Both deals invest $10,000,000 and return $16,400,000 in total, so both are a 1.64x equity multiple.
| Deal A: no interim cash flow, all $16.4M at the end of year five | 10.40% IRR |
|---|---|
| Deal B: the same $16.4M returned at the end of year two | 28.06% IRR |
| Deal C: $400k, $450k, $500k, $550k then $14.5M in year five | 11.14% IRR |
| Identical multiple, IRRs from 10.4% to 28.1% | timing is the whole difference |
This is why the two measures are always quoted together. Deal B is not three times better than Deal A. It is the same profit collected three years sooner, and whether that is worth more depends entirely on what the capital does next.
Conventions worth knowing
- Quote IRR with the hold period attached. A 20 percent IRR over eighteen months and a 20 percent IRR over ten years are different propositions.
- Always state whether an IRR is levered or unlevered, and whether it is gross or net of fees and promote. Those four combinations produce four different numbers on one deal.
The common mistake
Optimising the hold period to manufacture the IRR
Because IRR rewards speed, shortening the assumed hold almost always raises it, and a model can be tuned to a target simply by selling earlier. The result is a return that depends on an exit the sponsor does not control, in a market that may not be there. Test the IRR across several hold periods and report the shape of the curve rather than the single best point on it, and read every IRR against the equity multiple at the same hold.
Related terms
- Equity multipleThe equity multiple is total distributions divided by total equity contributed, expressed as a multiple. A 2.0x means an investor received two dollars back for every dollar put in, counting the original dollar.
- Cash-on-cash returnCash-on-cash return is a year's cash flow after debt service divided by the total equity invested. It measures the current income yield on the money actually at risk, ignoring appreciation and any eventual sale.
- Going-in versus exit cap rateThe going-in cap rate is year-one NOI divided by the purchase price. The exit or terminal cap rate is the rate applied to the forward NOI at the end of the hold to estimate the sale price. The spread between them is one of the largest and least evidenced assumptions in any underwriting.
- Preferred returnA preferred return is a threshold rate of return that limited partners receive on their capital before the general partner participates in profits beyond its own pro rata share. It is a priority in the distribution queue, not a promise that the money will be there.
- Distribution waterfallA distribution waterfall is the ordered set of tiers that determines how cash is split between limited and general partners. Each tier is filled completely before any money reaches the next one, and the general partner's share rises as it goes.
- Cap rateA cap rate is a property's net operating income divided by its value or price, expressed as a percentage. It is the unlevered first-year yield on the purchase price and the standard shorthand for what a market is paying for a stream of property income.
Keep reading
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.