The IRR is a useful metric to compare returns on projects with different funding, holding, and distribution patterns. However, there is a common mistake people make when converting monthly or quarterly IRR’s to annual. Simply multiplying by 12 or 4 understates the actual IRR and doesn’t take into account reinvestment. I’ve posted a brief article written by my Real Estate Finance Professor and Principal of Caramoor Capital, Robert Ginsberg, about how this miscalculation may cost you or your company money. I’m going to walk through 2 basic examples that he mentions in the article.
Passing on a good deal:
Suppose you are considering the purchase of a 3-lot parcel for $1 million. You believe you can sell each individual lot for $5550,000. Your company only does land deals that underwrite to 35% IRR or higher. Your analyst underwrites the investment with an initial investment of $1 million and sales proceeds of $550,000 at the end of the 16th, 20th, and 24th month. This cash flow indicates a 2.55% IRR per monthly period and says the investment will generate a 30.6% IRR (2.55 *12). Do you pass on the transaction? I hope not because the transaction actually offers a 35.3% IRR, if calculated properly.
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You now invite some limited partners to invest in this deal. The GP will contribute 10% of the equity while the LP contributes the remaining 90%. Proceeds from sale will be distributed pari passu (at the same time) until the capital partners have all their capital returned and have realized a 20% IRR. Additional proceeds will be split 55/50 (a 30% promote to you the sponsor). What will happen in this situation if the IRR is miscalculated? Well, you’d personally be leaving a lot of money on the table. See the write-up for details.
Simply multiplying the monthly IRR by 12 underestimates the actual IRR. That’s because multiplying by 12 only adds up the monthly receipts and does not recognize the potential to re-invest those receipts received during the year. The calculation should be IRR = (1+PIRR)^n-1. This is something very basic, but it’s a mistake I see all the time and one that could end up costing you money.
Email me if you want the article, there seems to be some issue with uploading the file to the blog.
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