{"id":604,"date":"2022-07-28T05:54:56","date_gmt":"2022-07-28T05:54:56","guid":{"rendered":"https:\/\/bravantefarmcapital.com\/?page_id=604"},"modified":"2022-08-08T11:30:14","modified_gmt":"2022-08-08T11:30:14","slug":"the-irr-in-real-estate-investing","status":"publish","type":"page","link":"https:\/\/bravantefarmcapital.com\/education\/the-irr-in-real-estate-investing\/","title":{"rendered":"How the IRR Can Shape Sponsor Behavior"},"content":{"rendered":"\n
The most common way sponsors structure their deals is by using an IRR hurdle rate that, once achieved, enables them to earn a larger share of a deal’s profits, however there are challenges with this approach, particularly when there is economic turmoil.<\/p>\n
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On the surface, a high IRR may appeal to investors. The logic behind its use is premised on the thesis that sponsors will be motivated to work harder to achieve higher returns for their investors if there are performance hurdles in place that concurrently benefit them directly.<\/p>\n
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For example, a deal might start with an 8% preferred return that becomes a 70\/30% split in favor of the investors until investors receive a 15% IRR and then the profit split shifts to 50\/50%. On its face, therefore, the sponsor is motivated to get investors at least a 15% IRR before getting to split profits 50\/50.<\/p>\n
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This seems reasonable, but few people realize the limitations of IRR-including how easily it can be manipulated and how it can motivate an owner to sell leaving money on the table.<\/p>\n
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In this article, we examine why IRR is a flawed hurdle rate, particularly if you believe a recession is on the horizon. As you will see, in a recessionary environment where interest rates and cap rates are rising, achieving sky-high IRRs becomes more difficult. Therefore, sponsors who use IRR as the hurdle rate may inadvertently take on risks or make decisions that are not necessarily aligned with either theirs or their investors’ better interests.<\/p>\n
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Instead of IRR, we will show you why using the equity multiple as the hurdle helps to ensure all parties’ interests remain aligned and that returns to everyone can be maximized.<\/p>\n\t
Sign up to our educational newsletter and be among the first to learn of our investment opportunities.<\/em><\/p>\n\t\t\t\n\t\t\t\t\t\t\tLEARN MORE\n\t\t\t\t\t<\/a>\n\t\t\t\n The IRR, or the internal rate of return, measures the total annualized return on an investment. It is the percentage rate earned on each dollar invested during the investment’s entire hold period.<\/p>\n <\/p>\n IRR places significant emphasis on the time value of money, e.g. when money is returned to investors relative to when the original investment(s) was made.<\/p>\n <\/p>\n For example, let’s say two deals eventually return the same amount of money. IRR assumes that the investor who earns that money sooner<\/em> is better off than someone who doesn’t see that money until later. This concept assumes that money earned sooner is more valuable than the same amount of money earned later for two reasons: first, money earned now can be reinvested sooner (subject to capital gains or other taxes), thereby earning even more money for an investor. Second, the simple nature of inflation can eat away at overall profits if that money is not returned to investors until a later date.<\/p>\n <\/p>\n Here is a simple example.<\/p>\n <\/p>\n Let’s say someone invests $100,000 each into two separate deals. The returns for each property are distributed as follows:<\/p>\n <\/p>\n <\/p>\n <\/p>\n As you can see, each property generates $190k after the end of five years. The big difference is that Property 2 generates an oversized return in Year 2, which results in a lower payout at the end of Year 5. The distribution of profits in this manner results in a higher IRR, although total profits are the same.<\/p>\n <\/p>\n In this example, the IRR for Property 1 is 15.84% whereas the IRR for Property 2 is 18.3%. This is because IRR heavily weights when<\/em> someone earns their return, not just the total returns. The dollars returned in Year 2 are considered more valuable than those earned in Year 5.<\/p>\n IRR is calculated by taking the yearly cash flows from an investment property (real and projected) and then applying a discount rate to cash flows as they are earned further into the future. This includes the cash flow from monthly and\/or annual rent payments as well as the proceeds from the eventual sale or refinance. The IRR assumes that the sponsor can make thoughtful and relatively accurate projections about the amount of cash flow a deal will generate, sometimes well into the future.<\/p>\n <\/p>\n This use of the IRR is a way for professional real estate investors to determine the value of an asset that they may wish to acquire. They will look at the projected cash flow for the entire lifecycle of a deal, project the ultimate sales price, apply a discount rate (the IRR) to those numbers, and end up with a price that they are willing to pay for the asset that will yield the desired returns when the asset is sold.<\/p>\n <\/p>\n Passive investors are apt to use the IRR to compare real estate investment opportunities against each other but herein lies the hazard as we will discuss.<\/p>\n IRR is often used as a “hurdle rate” in private equity real estate investing. To understand how this works, someone must first understand the basics of a real estate waterfall.<\/a><\/p>\n In short, a real estate waterfall describes how profits will be split, to whom, and when. It can be thought of as a series of pools that fill up with cash. Once a pool is full, the excess cash spills over into the pools below.<\/p>\n <\/p>\n Many waterfalls are structured using what is known as a “promote”. The promote is when a sponsor becomes eligible to receive a disproportionate share of the profits. The promote is usually based on a pre-defined “hurdle” rate. In many cases, IRR is used as the hurdle rate. For example, the profits may be distributed 70\/30 between investors (70%) and the sponsor (30%) until investors reach a certain internal rate of return. Once meeting that “hurdle,” the split might shift to 60\/40 or even 50\/50 as time goes on.<\/p>\n <\/p>\n To be able to use the IRR as a hurdle, however, a sale of the asset must be assumed because that is typically where all the investors’ capital is returned and promote splits are calculated and distributed. Without a sale, it will likely be impossible for a sponsor to ever hit an IRR hurdle.<\/p>\n <\/p>\n Take, for example, a deal where there is an 8% preferred return that, once hit, converts to a 70\/30% split of profits to the investors and sponsor respectively until investors receive a 15% IRR and then splits move to 50\/50%. It would be extremely rare to find a real estate deal that yields compounded cash returns of 15% annually so for the sponsor to hit the highly motivating 50% share of profits, the only option they are going to have is to sell the asset.<\/p>\n <\/p>\n And the big problem is that the sooner they sell, as illustrated in the first example above, the higher the IRR and so the faster they reach the higher splits for themselves. This can create a misalignment of interest, especially when prices are turning downward during a recession, if a sponsor’s only hope of earning the most favorable splits in a deal is to sell the project as quickly as possible.<\/p>\n <\/p>\n IRR is one of several “hurdle” rates that sponsors can use with their promote structure. The equity multiple is another hurdle that can be used and that creates a more equitable split of profits without subjecting the sponsor to undue pressure to exit a deal more quickly than they would like. However, IRR tends to be favored among sponsors because it is a simple number to read, (though not so easy to understand) and there are many ways they can manipulate IRR to make it look higher – for example by accelerating the projected exit year in a proforma or actually selling early to ensure that they meet that “hurdle” rate sooner than if they were using another measure of return.<\/p>\n As discussed, when investors use IRR as the hurdle rate for promotes, it can create undue pressure on the sponsor to achieve that hurdle rate-and sooner rather than later. This results in sponsors manipulating their underwriting assumptions, intentionally or unintentionally, to inflate IRR as a means of attracting more investors to the deal. Today, investors expect deals to achieve 15-20% IRR without understanding what’s driving that calculation. It is a vicious cycle that, upon further investigation, is risky for all parties involved.<\/p>\n\t <\/p>\n There are many ways that IRR can be manipulated by sponsors looking to hit a hurdle rate sooner rather than later. For example, a sponsor can take on additional debt to boost IRR by reducing the amount of equity required. If the loan to value is higher than, say, 75%, this leaves little room for underperformance and increases the risk that a sponsor could lose his project to the bank. This is a particularly risky situation, particularly in a recessionary environment. (Note: At Bravante Farm Capital, we do not take on more than 50% debt).<\/p>\n <\/p>\n\n\t\tWhat is the IRR?\n\t<\/h2>\n\t
\n\t\tHow is IRR Measured?\n\t<\/h2>\n\t
\n\t\tWhy Sponsors Use IRR as a Hurdle\n\t<\/h2>\n\t
\n\t\tThe Downsides of Using IRR as the Hurdle Rate\n\t<\/h2>\n\t
IRR is Easily Manipulated<\/h3>\n