If you are analyzing a new property or acquisition, one of the most important metrics that you should be utilizing is internal rate of return (IRR). IRR is the discount rate at which net present value of an investment is equal to zero. The net present value is the lump-sum value today of a string of future cash flows discounted back to today at a specified discount rate. Essentially the IRR metric is a time value of money metric, representing the true annual rate of earnings on an investment. The IRR metric will provide you with an annualized rate of return by taking into account your net operating income, capital expenses, and loan metrics. It is important to understand that there are two different metrics of IRR.

levered Internal Rate of Return

Levered IRR takes into consideration your debt services on the purchase, sell, and the string of cash flow after debt services. In using levered IRR, it is common that you will see a higher return because you are leveraging your cash flow against the debt.

unleveraged Internal Rate of Return

Unleveraged IRR only takes into account net operating income and capital expenses into its calculation. It does not take into account debt financing, or debt services. When you are not taking the financing into consideration, it is common unleveraged IRR will show a lower return. This is because when you take financing into account, you are not calculating off the full purchase price but rather based off the amount of money that you put into the deal.

Example:

In this example, you purchase a property for $4,000,000 with 30% down. You plan to hold the property for 4 years. Each of those 4 years you make a net operating income of $300,000. Your debt services for each year is $170,000. At the end of the 4^th year, we expect we can sell the property for $4,475,000 after closing costs. We will have a remaining loan amount of $2,606,000. What is our Levered and unlevered IRR?

After calculation, you can see that the leveraged IRR is much higher than the unlevered. This is because in reality, you are not putting the full $4,000,000 of your own cash into the property but only covering 25% of the investment cost with your own equity. You may be receiving a discounted cash flow due to paying your debt services but relative to the amount of money that you put into the investment you are receiving higher returns than if you purchased the property outright. This is leveraging debt.

What makes a good IRR?

Now that we know how to properly calculate IRR, what makes a good rate of return? Relatively speaking, it depends on two key factors on what type of return you should expect. The first is your risk assessment. The higher the risk of the acquisition, the higher the returns you should expect to receive. The lower the risk, the lower the returns you should expect to receive.

The second factor is timing. If you are planning on doing a long-time hold, you should expect a lower IRR. Likewise, the shorter the hold period, the higher the IRR you should expect to receive. It is important to understand that the sooner you receive the cash flow over the hold period, the higher your IRR will become.

Depending on how long you plan on holding the property and the level of risk associated with the investment, the preferred ranges for levered IRR is between 7-20% and for unlevered IRR is 6-11%. It really depends on you as an investor on what type of return you are ultimately satisfied with as well as the level of risk you are wanting to take to achieve the higher return.