Prerequisite II: Internal Rate of Return

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Summary

The internal rate of return (IRR) is one of the most common metrics used to evaluate the performance of a real estate investment.  It is most certainly the most misused performance metric.  The metric is regarded both in the form of the unlevered IRR (property-level IRR) and the levered IRR (equity IRR).  On the most basic level, the IRR can be thought of as the average annual return an investment generates when looking back at the cumulative cash flows after the investment has been exited.

It is important to understand what IRR is, and what it is not.  It is also critical understand its severe limitations.  When you do, you will see that it is just one more “brick in the wall” that goes into making a sound real estate investment decision.

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Key Terms

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The annual rate of return that generates a NPV of zero for a stream of expected (or actual) cash flows; that is, the present value of the expected income exactly equals the present value of the investment.  Generally thought of as the average annual return to equity over an investment period, as measured after exit.  Can be measured on an unlevered or levered basis, the former assuming no use of debt financing, and the latter assuming use of debt.

The single discount rate, expressed as a percentage, that sets the NPV of expected future equity cash flows equal to zero. Generally thought of as the average annual compounded return to equity as measured after exit.

Assuming no use of debt financing in an investment, the annual rate of return that generates a NPV of zero for a stream of expected (or actual) cash flows.  Generally thought of as the average annual return to equity over an investment period, as measured after exit.

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