How Internal Rate of Return (IRR) Can Mislead Investors

Topic:  • By Michael Episcope • April 23, 2018 2,424 Views

How Internal Rate of Return (IRR) Can Mislead Investors

Internal rate of return (IRR) has become the measuring stick for private investment managers, but this metric has serious limitations that all investors should understand. Real wealth is created through the compounding of money over time, which is captured in the annualized return metric, but not IRR. Many investors mistakenly compare IRR to annualized returns to make investment decisions, which can be a costly mistake. It’s important for investors to understand how IRR differs from annualized returns to make smarter real estate investing decisions.

Annualized return is the amount of money an investment made or is anticipated to make every year it is invested. For example, a $1 million investment that achieves an annualized return of 8% will be worth more than $10 million in 30 years, after factoring in compounding.

IRR, on the other hand, attempts to give investors the equivalent annualized rate of return but takes into account the timing of cash flows, even if money is invested for short periods of time such as days or weeks. IRR also assumes all distributions will be reinvested immediately, which means there is a built-in compounding assumption that actually doesn’t happen.

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The real challenge with IRR is that it does not explain in quantifiable dollars how much money you’ve made. For example, unlike the quantifiable annualized return example above, we don’t know how much a $1 million investment that achieves an IRR of 8% over 30 years is worth today.

Below is an example that highlights IRR’s limitations by looking at a $100,000 investment over a three-year period:

Initial Investment $(100,000)
Cash Flow in Year One + $50,000
Cash Flow in Year Two + $50,000
Cash Flow in Year Three + $20,000
Total Gain on Equity $20,000

The IRR for this investment is actually 11.2% over the three-year period. The easiest way to calculate this is to plug the cash flows into excel and use the “=IRR” function. The formula is simply discounting the cash flows back to generate the investment’s IRR. The most important point here is that the investment’s gain was only $20,000, or 20%. To achieve the same total return on annualized basis, the investment would need to generate 6.3%. In other words, had you invested $100,000 into an investment that gained 6.3% annually, the investment would be worth $120,000 after three years. If the $100,000 were to have grown by 11.2% on an annualized basis, the gain would be closer to $37,000. Before you commit to that private equity fund that generated a 20% annual IRR, determine how much actual wealth they created by looking at the total gain on invested equity, or multiple.

To further illustrate the differences between IRR and annualized returns, below I compare two $100,000 investments that both generate a 15% IRR, but produce far different gains.

Scenario #1:
Initial Investment $(100,000)
Cash Flow in Year One + $50,000
Cash Flow in Year Two + $50,000
Cash Flow in Year Three + $28,500
Total Gain on Equity $28,500
Scenario #2:
Initial Investment $(100,000)
Cash Flow in Year One + 0
Cash Flow in Year Two + 0
Cash Flow in Year Three + $152,000
Total Gain on Equity $52,000

The first example resulted in a total gain of 28.5%, while the second example yielded a total gain of 52%. This example illustrates the reason why comparing two investment opportunities to one another using IRR alone can be costly. Both investors had their money tied up for three years but one made far more than the other. In Scenario #2 above, it turns out that the 15% IRR is actually the same as a 15% annualized return because all of the cash flow happens at the end. The $100,000 investment is essentially compounding at an annual rate of 15% each year.

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Watch Michael Episcope explain why investors shouldn’t solely rely on IRR when measuring performance.

To be fair to IRR, getting money back sooner, rather than later, is better and certainly helps in reducing risk. Cash flows that happen far out in the future are generally riskier than ones expected to occur earlier. In scenario #1 above, the investor would presumably be immediately investing any cash flow they receive into other investments. However, you don’t know what investments will be available at that point in the future and those investments would most likely not be generating the same IRR. It also takes time, energy and discipline to find a suitable place to reinvest those distributions.

It should be evident by now that even though IRR and annualized returns look and feel similar to one another, they are very different metrics. Chasing high IRR in short durations is one of the biggest mistakes made by investors. A private real estate manager who produces high IRR may not actually produce any real wealth, which is why one needs to also look at the metric of total return or multiple on equity. Sometimes it’s better to find good long-term investments and let the power of compounding work for you. You may be better off, in the long run, achieving a 10% annualized return than chasing 20% IRR’s. As the great Warren Buffett says, “Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”

Posted By

Michael Episcope
Principal

Michael is principal of Origin, co-chairs the Investment Committee and oversees investor relations, marketing and company operations. Michael brings 25 years of investment and risk management experience to the company and believes that calculated risk-taking in inefficient markets is the key to building wealth.