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How Depending on Internal Rate of Return Calculations Alone Can Lead to Problems

Whether due more to usefulness or force of habit, real estate investors, finance professionals, and many others use the internal rate of return (IRR) to evaluate capital projects. In commercial real estate, where the tool is particularly popular, IRR is widely used to help investors wend their way through what can be a complicated market, and to generally make wiser decisions. However, IRR does have its shortcomings, which we’ll discuss, along with how depending on internal rate of return calculations alone can lead to problems.

Internal Rate of Return

Let’s define terms. Internal rate of return is a metric that is used to find out how a current project is performing or what the return rate will likely be on a possible project. It essentially tells you what kind of annual growth rate you can expect from an investment.

The IRR Calculation

We won’t go into the complicated IRR formula here; you wouldn’t need to manually calculate it, anyway. What’s important is that it focus1es on two main factors: profit and time. The former is basically whatever earnings exceed the amount invested. No surprise there. The issue of “time,” meanwhile, is a bit more involved since there do exist factors such as unanticipated housing trends that can affect a house’s value.

 

Also, it’s a fact that the value of money does change over time. For example, $25 today is not worth what it did a decade ago, nor will it be worth the same 10 years from now. So, an investment’s current or prospective profitability must be considered in relationship to time.

How IRR Helps

 

We’ve nibbled around some of the benefits of IRR, which include:

 

  • Factors in time value of money (TVM). We broach this above. Since all future cash flows are considered in the calculation, all cash flows are equally weighted when determining cash values from a time perspective.
  • Ease of use. The formula is complicated, sure enough, but with just a few entries into a special calculator, you’ll get instant results.
  • Helps with decisions. Real estate investors commonly use IRR to help them decide between projects, or even between a project and a different kind of investment altogether. This helps set priorities.
  • Complements other tools. Internal rate of return can be used with other metrics to include other business factors, which is a smart move.

 

Using IRR Alone

 

As we say above, there are other metrics, such as net present value, that can be used in tandem with IRR as a preventive measure to make sure you cover all bases. After all, each tool is different, and some of them work better in other fields. Just be certain that you use a tool that’s pertinent to your venture.

 

Internal rate of return does have shortcomings, including:

 

  • It doesn’t include factors such as financial risk, inflation, capital costs, or risk-free rate.
  • It’s foggy about profit. It’s a challenge to know, in real terms, at least, the amount of profit that’s been realized. That’s because you can’t project how much today’s dollar will be worth in the future.
  • It doesn’t factor in a project’s scope or size. Internal rate of return exclusively sizes up cash flows against how much is being spent to generate those cash flows.
  • It doesn’t factor in potential costs including fuel and ongoing maintenance that would affect future projects.
  • It doesn’t factor in reinvestment rates. It’s not always a realistic assumption that the value of future cash flows can be reinvested at the same rate as the internal rate of return. In assuming that the investor has multiple projects, the IRR can throw off your budget.

 

Ultimately, while the metric is indeed useful, you have a sense of how relying on IRR calculations alone can lead to problems. This is all information you need if you’re considering entering the real estate market, or if you’re seeking to strengthen your existing knowledge. If you’d like more information on the world of real estate, you may want to consider checking out the alternative investment platform Yieldstreet, which has a cache of relevant resources.

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