If you’re a subscriber to the EquityScout.com economic model you will have noticed by now that Internal Rate of Return (IRR) is the primary result that we use to rate the attractiveness of a real estate investment. This is a note to comment on what IRR is all about, and why we like it here at EquityScout.com.
As investors we’re always evaluating different alternatives for our investing dollars. Stocks? Bonds? Mutual Funds? Or…real estate? All of the options have different levels of risks and rewards. At the end of the day we need a measure to indicate if the reward that we expect from a given investment is worth the risk and effort that will be required to reap it.
IRR: Bang for you Buck.
IRR is a useful measure for comparing dissimilar alternatives. Suppose you buy a bond with a $1,000 face value, a 5% coupon and a ten year maturity. You’d pay $1,000 to purchase the bond and then receive an annual payment of $50. In ten years you’d get your $1,000 back. The cashflow would look like this:
This investment yields an IRR of 5%.
So if you have $10,000 to invest the question you might ask yourself is: should I go out and buy ten 8% coupon bonds, or should I use the $10,000 to invest in a rental property?
Risk and Reward
That 5% return in the example above is pretty easy money. The risks are low, and all you have to do is cough up the $1,000 and the coupons start rolling in. However, a 5% return isn’t anything to get particularly excited about. Investing in a rental property is an alternative, but in return for the additional effort and risk you’d expect the reward to increase proportionately.
Say you took that $10,000 and put $5,000 down on a $100,000 property and used the other $5,000 to fix it up and get it ready for rental. Is this a more attractive investment than buying bonds?
Well it depends on the rent you can charge, taxes, expenses, property appreciation rates, mortgage terms, and a myriad of other variables. All of these factors will contribute to determining your annual cashflow. You’d expect a return that is considerably more attractive than the %5 that the bond gives you. If, based on your assumptions, the economic model tell you that this isn’t the case, you’ll probably want to keep looking.
Problems with IRR
In some circles there’s a surprisingly passionate debate about whether or not IRR is a good measure. Arguments against the measure tend to follow two trends: technical objections and practical.
IRR has some technical drawbacks (assumptions about reinvestment of cashflow, possible multiple answers, etc.). I won’t get into these here, except to say that all approaches are going to have some limitations. If you use IRR as a compass to point you in the right direction (as opposed to an infallible final answer) then our opinion is that it’s a pretty good measure. Maybe I’ll elaborate in a future post if there’s any interest…
The practical objection is a bit stickier. This objection tends to go along the lines of “you can back into any rate of return you want if you play with the variables and assumptions.” This is true enough: it’s the old garbage-in-garbage-out syndrome. There’s no getting around this one, but the main benefit of the EquityScout.com model is that it forces you to be explicit about your assumptions. If your evaluation yields a respectable expected return of 15%, but only if you enter a sky-high property appreciation rate then at least you’ll know where the weak link was when the investment doesn’t pan out as expected.
Look for an article on this topic soon in the Media Room.