Encyclopedia
Internal rate of return (IRR)
The discount rate that makes the present value of all cash flows equal zero. It's a common way to measure return over a holding period.
For example: An investor compares two deals with different holding periods using IRR. (Illustration only, not a real deal.)
This is a general industry term with no single official definition. Your lease or contract wording controls.
Example only, not a real client. Say you compare two buildings over a planned ten-year hold. One pays more cash each year; the other pays less but is likely to be worth more when you sell. Working out the internal rate of return for each, with the timing of each cash flow, gives you one figure to compare them fairly.
What I’d tell a friend
IRR is only as good as its assumptions. Ask to see the rent growth, exit capitalisation rate (cap rate) and sale price behind any IRR you are shown.
Why it matters to you
A high IRR can come from optimistic rent growth, a rosy sale price or a lot of borrowing rather than a good property. Ask what the return looks like with flat rents and a lower exit price before you rely on it.
How to use it in your deal
Buyers should treat IRR as a projection built on assumptions about rents, costs, financing and sale price. Ask what happens if the sale is delayed or the exit cap rate is higher; IRR is very sensitive to sale price and timing. Compare it with simpler measures like cash-on-cash and equity multiple to avoid surprises.
Sellers and sponsors presenting IRRs should show assumptions clearly. Investors in syndications should compare sponsors' past projected and actual IRRs. Owners can use it to decide whether to sell or refinance. Lenders don't use it. Compare IRR with equity multiple and cash-on-cash, since IRR rewards speed and can make a small quick profit look better than a large slow one.
Ask what exit cap rate and sale timing drive the number, and run a version with a later, lower sale to see how fragile it is.
Mistakes I see
Trusting optimistic models. Ignoring timing risk. Comparing levered and unlevered IRRs.
In BC and Vancouver
No statute defines it. Securities rules apply when IRRs are presented to investors in offerings.
Official sources: BC Securities Commission: investors · Bank of Canada: key interest rates
What it is
Internal rate of return is the yearly return that makes the present value of an investment’s future cash flows equal to what you put in. It accounts for when you receive money, not just how much.
It is widely used to compare investments with different hold periods and cash flow patterns.
Reading it carefully
Small changes in the sale price or exit cap rate at the end can swing the IRR a lot. Test a few scenarios, including a weaker sale.
Use it with cash-on-cash return and equity multiple, so you see both the yearly income and the total gain. I can build these scenarios for you.
Questions to ask before you sign
- What assumptions drive it?
- Is it levered or unlevered?
- What if the sale is delayed?
- What's the equity multiple?
Keep reading
Related terms: Discounted cash flow (DCF), Cash-on-cash return
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General information for British Columbia only. It isn’t legal, tax, accounting or financial advice, laws and rates change, and reading it doesn’t make you my client. Any numbers or scenarios are hypothetical. Check the linked official source and talk to a lawyer, accountant or other qualified professional before you act or sign anything. See the terms and disclaimer.