Jansen Multifamily Team Blog

Internal Rate of Return (IRR) is arguably the most holistic measure of an investment property’s return potential; that being said, many commercial real estate professionals fail to utilize this key metric, or underestimate its’ utility in measuring value.  Investopedia (www.investopedia.com) defines IRR as “[T]he discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero.”  In other words, when using IRR to measure the performance of an apartment investment, the commercial real estate practitioner must establish a target yield (discount rate) over a period of time, and then project the year-over-year performance of the three key return components of a real estate investment: amortization, appreciation and cash flow.  Running a simple “discounted cash flow analysis” will solve for IRR and provide valuable insight into the strength of a particular investment.  For further discussion of the impact of debt on IRR, please refer to “Part 3” of the Jansen Multifamily Team’s Investing 101 series concerning financial leverage.

Let’s assume you are an investor looking at acquiring a 50 unit apartment building in the Puget Sound Region.  The building consists of 50 two-bedroom, two-bath units, each 1,000 square feet and collecting $1,100 per month in rent, with additional “miscellaneous other income” at $10 per unit per month.  Market vacancy rates are 5% and expenses are running at 40% of effective gross income, inclusive of replacement reserves.  Loan sizing metrics are as follows: 1.25 minimum debt service coverage ratio (DCR), 75% max loan-to-value (LTV), 5.5% interest rate, 30 year amortization.  Market CAP Rate is 6.5% and your target pre-tax discount rate is 13%.  As a savvy real estate investor, you must quantify all of the aforementioned data by establishing an “annualized property operating data” (APOD) pro forma for year 1:

Applying a 6.5% market CAP rate to the above-listed NOI establishes a “preliminary value” for the asset of $5,837,677.  This value is only preliminary because we have not 1) sized for our loan amount and 2) applied the “time value of money” to this asset to measure its’ periodic performance.

In this example, our loan would be LTV-constrained, which would correlate to an amount of $4,378,000 with a down payment of $(1,459,677) to purchase the property; this down payment would be reflected as a negative number in “Year 0” of your discounted cash flow model.  Subtracting the annual debt service (loan payments) of $(298,294) from our above-listed NOI results in year one pre-tax cash flow of $81,155.

Application of the time value of money principal to this investment requires us to 1) establish annual income and expense growth assumptions, 2) establish annual vacancy rates, 3) determine your holding period (how long you will own the asset), 4) establish your disposition CAP rate and 5) project your disposition “cost of sale”.  In this example, let’s assume that income will grow at 3% annually, expenses will grow at 3.87% annually, vacancy is finite at 5% annually, you will hold the property for 10 years, your disposition CAP is 6.75% and your disposition cost of sale is 8.5% of disposition sales price.

The application of the aforementioned assumptions to our discounted cash flow model establishes our “t-bar” (www.ccim.com), which solves for IRR based on periodic cash flows and reversion, or sales proceeds, which is comprised of 1) reduction of the original loan balance (amortization) and 2) appreciation of the asset’s value:

IRR = 13.2%

This measure of investment performance validates our “preliminary value” by exceeding our target discount rate of 13%.  Thus, this investment would be a “go”.

IRR can seem like a complex valuation tool, however, multiple resources, such as the CCIM Institute (www.ccim.com), provide discounted cash flow forms that enable an investor to quickly solve for IRR and adequately measure the risk of a particular investment.  Regardless of the resources you utilize, a keen understanding of IRR and its’ relevance in establishing an assets’ value is key to success in commercial real estate investing.