Why The Internal Rate of Return Can Be Misleading

The use of the internal rate of return (IRR) as an investment metric is ubiquitous in the world of investment analysis. In real estate investment analysis, it’s no different.

However, it should never be used in isolation when making an investment decision. To illustrate the internal rate of return’s shortcoming, let’s take a look at two hypothetical investments.

Which investment would you take?

Investment A: $200 investment to get $172.70 a year back in returns for every year for 10 years

Investment B: $200 investment and get $0 from years 1 – 9 but get $100,000 in year 10.

So which would you take? If we look only at the IRR, we’d get the following result:

According to the IRR, these two investment opportunities are equally attractive. But if you have an inclination that Investment B might be the better option, all things equal, then your intuition is correct.

Something is amiss here when only looking at the IRR. What’s going on?

The Internal Rate of Return (IRR) Measures Efficiency of an Investment

How quickly does the investment return cash flows to the investor? All things equal, the earlier the cash flow, the higher the internal rate of return.

Let’s look at a third investment to see just how sensitive the IRR is to the timing of the cash flows

Investment C: $200 investment to get $372.40 in year 1 and nothing thereafter.

Here, Investment C, with a very different cash flow signature than the others, also yields an IRR of 86.2%

All things equal, you can clearly see this is the worst of the three options.

So, while the internal rate of return measures the efficiency of an investment’s returns, it fails to measure the magnitude of those returns.

To do that, we must defer to other measures.

Measuring the Magnitude of an Investment Return with the Cash Multiple and Net Present Value

Two popular investment metrics often used alongside the internal rate of return are the Cash Multiple and the Net Present Value.

Cash Multiple: The ratio of the sum total of the net investment returns divided by the initial investment

So in our examples above, it would be the “Cash Flow From Investment” divided by the Investment (i.e. $200).

Net Present Value: The value today of the sum of all future cash flows from an investment

For the net present value, the main idea is this: A dollar today is worth more than a dollar tomorrow (which is worth more than a dollar in 10 years).

So how do these investments look now when we put the cash multiples and net present values in next to their internal rate of returns? (Note: A discount rate of 7.5% is used for the NPV calculations).

Now, we can clearly see that Investment B is the best option, even though all of the IRR’s are identical. When evaluating investment opportunities, be sure to compare both the efficiency and magnitude of their investment returns.

To see the calculations used in these examples, click here.

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Do you use these metrics in your investment analysis?