How to Invest in Commercial Real Estate

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Episode #023 - A Basic Introduction to Internal Rate of Return or IRR in Commercial Real Estate!

by Criterion, Braden Cheek, Brian Duck
February 23rd 2021

On today's episode we go over the basics of using the Internal Rate of Return or IRR metric in evaluating commercial real estate investment. We have our hosts Brian Duck and Braden Cheek from The C... More

Yeah I'd take a lower Ir if uh the deal is less risky or if it um uh is less time consuming for me. Um If it's a longer hold and I think well if if I couldn't sell this thing in a couple of years, what am I gonna do with that money? But if I've got a you know a 10 year or 15 year deal that I just have to place the money and let it go. And then that's another reason to take lower ir higher cash on cash like you were saying because then you can take that cash and you can you can reinvest it rather than getting it at the end. Mhm. Yeah. What is up and welcome back to how to invest in commercial real estate. My name is Brandon. I'm with brian and Joel and today we're gonna talk a little bit about internal rate of return, what is going on guys? What's up much? So today could be a doozy because internal rate of return is insanely complicated. Um To define it, we're gonna have to use words that are also complicated. Um So just bear with us and then we will get to the point of how we use it. I mean that's the big thing. Internal rate of return is a great metric to evaluate real estate. It's a very common metric to evaluate commercial real estate and a bunch of other investments in general.

Why don't we start with the actual definition? Yeah. Yeah. Yeah. All right, go Joel. No I think brady is going to read it to, right and what's the actual definition? Yeah. So the internal rate of return is a discount rate that brings all of the cash flows down to zero technically speaking, The present value of zero, correct? Well I think it's it's all the cash flows of the investment. The NPV of all of those equals zero, correcting the original investment, correct. So that's kind of complicated. The discount rate is just what return you're getting on your money. The assumed return you would want. And we've talked about it before, but the time value of money is really important in real estate because not only how much money you make in real estate deal is important, but when you get it is also important. And so that's what internal rate of return is doing, its taking a future cash flow and it's bringing it back As if you invested a certain amount at a let's say a 10% discount rate. It's bringing that back to today one.

In that way you can you can evaluate uh different real estate deals. Maybe one is front loaded with some cash flow. Maybe one has a huge sales price at the end or you're building equity quicker because of the loan and it brings all those back to day one and makes them even playing field to see okay which one is actually getting me a better return. Yeah. So you know, I think up until this point we've talked a ton about commercial real estate and we're just real estate in general. It throws cash at you from every direction you're getting appreciation, you're getting depreciation, you're getting cash flow, you have capital expenditures, you've got debt, you may get new debt in the middle of an investment, right? So the I. R. Are saying okay all of those cash flows, all of those activities going on, we're going to try to break that down to an annual rate of return that you as an investor would get over the time period that we're going to have your money. That's generally speaking what an I. R. R. Is. Right. Yeah. It's a little complicated to calculate. But yeah it's kind of saying, Hey you're gonna invest 50,000 with us and you're gonna be building equity along the way and you're gonna be getting some distributions along the way, maybe maybe there's a year, you don't get any distributions and then we sell the property and we make money.

Well how do I know exactly what my rate of return was because it wasn't like I was earning interest on that money every year. I was getting at different times. So yeah that's what it does is it's a way to calculates through the bringing all the cash flows to a NPV of zero is what is that annual compounding average rate of return? Yeah it's no different than what companies do every day, right? Company has a certain amount of money to spend. They're trying to decide, let's say it's a manufacturing company and they say it's Tesla and they're deciding whether or not to manufacture cars or buy Bitcoin. Yeah. Or maybe they need a new a new piece of equipment to assemble their cars. So they they have a certain amount of investment on that piece of equipment and they want to see what their I. R. Is going to be. Um, and it's a good way to compare different investment strategies are different investment avenues. Yeah. Yeah. You can compare it to um what you can do in the market in the stock market. Um, even even businesses will do that sometimes if they're on a certain project the I. R. S to too low, they're either going to find somewhere else to put their money or they might invest the money themselves uh, in the market or something other than in their own company.

Yeah. Well, you know, even a house flipper or something, you know, those guys maybe not using as sophisticated formulas to calculate are are taking into account their capital expenditures and the debt and the actual cash flow produces, you know, they may be just looking at rental payment minus mortgage equals cash flow times 12 boom, 20% when in reality it's 10 or whatever it is. And so why why do we use ir ir my at least my favorite way to analyze commercial real estate. Yes. One of my favorites is cash flow which backs me into the reason right? Because you have multiple deals, some are paying cash flow, some are not paying cash flow once an existing building. Once a non existent building that's that's going to be built. And you have to pay attention to the I. R. Because the I. R. Is telling you when and where kind of the money is coming from. If you have an eye, if you have a deal with 20%. You know, that's that's a completely different deal than I are. Are you know, it could have the same ir but it's paying you 10, 12, you know 15% a year in cash flow.

And and then, you know, at the end there's only a little bit of money being made from the sale. That's kind of what it's telling me. I don't I don't know if I answer your question or not. Okay, well I are in those two cases though, they may give you the same IR which so over a five year period, you essentially made the same annual average compounding rate of return on your money. So then the question then goes to your example, is is there a reason why you might take a lower IR deal versus a higher IR deal, I'd take a lower Ir if the deal is less risky or if it is less time consuming for me, um if it's a longer hold and I think, well if if I couldn't sell this thing in a couple of years, what am I gonna do with that money? But if I've got a, you know, a 10 year or 15 year deal that I just have to place the money and let it go, then then that's another reason to take lower iR higher cash on cash, like you were saying, because then you can take that cash and you can you can reinvest it rather than getting it at the end. Yeah, So here's gonna make sure it also make sure your investment less risky, right?

Because you're pulling the money out that you put into it. That's a really good point. Yeah. So if you're getting, you know, if your pitch to 20% Ir deal, but they're paying you 12% a year in cash flow. It's kind of the point I was driving to, who cares if you get the extra eight, you know, you already killed at getting the 12 and then if they're going to get you a pop when you sell this thing, that's a win, that's how they're getting you to 20 but if they were pitching a 20% I are are on another deal and it paid, you know, 4% in cash flow, but the 12% in cash flow deal had an I. R. R. That was you know maybe a few points less than that. You take the 12% in cash flow over the four if it was a few few percent in the back end because who you know who cares? Well I mean people might care I think whenever you're getting cash flow today from investments uh then that that total Ir. Is less dependent on future events. And so that that's a big distinction between higher cash on cash deals versus uh lower cash on cash deals but maybe have the same IR is that that future I are so much of the return of the investment depends on sale price or market conditions.

56 10 years from now. So they're both good but we tend to want to focus on higher cash on cash deals today. And to your point brian is giving our investors uh distributions every quarter. Uh They can reinvest that money. They can hold it in a money market and earn additional dollars which won't show up in the Ir we give them but but they could calculate what's called a modified our I. R. R. Where they're reinvesting the returns over over time maybe even in the stock market or something. And that would even increase the total return of the investment or by other real estate deals with that cash is coming out of really really compound the return. Yeah I mean you can you can kind of, we talked about cap rates recently so that kind of associate internal rate of return and cap rates you really can't, which is the beauty about it. I mean people are underwriting, you know really high R. R. S. And they may be buying an apartment complex let's say in a five cap, right? So it's paying out a few percent, they may be getting an interest only loan. So it's you know, the first few years have a lot heavier cash flow and then the principal payment kicks in.

They lower the cash flow a little bit. Maybe You go from double digits down to six or 7 or something like that. And then you have massive amounts of appreciation and an amazing market because you bought it in five cap for an amazing growth rent growth and then you get this big pop in the back end along with heavy cash flow in the first few years and then medium cash flow through the rest of the investment. An internal rate of return is really good in evaluating that because there's a lot of different ways where you're making money and a lot of different time period and like you said, you may go a year with amazing distributions and then Covid may happen. Well, good point. What was I gonna say about that? Um I can't remember, I'm sure it was good. Well I've got something while you think, you know, there's another metric that people use and maybe we should mention it Just so people don't get confused. And that's R. O. I. Return on investment. And the difference there you guys may have some input on this. But to me the difference there is that something that at the end of the project you can you can determine right, it's not a yearly thing. It's an overall return.

So you simply take the money you put in divided by the money that you got out. And uh and and that's your total returns. That's return on investment. Yeah and that doesn't have anything to do with time. Is the biggest distinguish er there. So internal rate of return has a time value of money. And and my biggest thing right as everyone wants to go make a million dollars but you can make a million dollars working at um you can make a million dollars working. Mcdonald's making minimum wage. If you live long enough, you know what I mean? Make a million dollars is chump change. How do you make a million dollars a year? How do you make a million dollars in a month? How do you make a million dollars next week? That's what I want to know. An internal rate of return takes that how much money you made and it says okay you've got a clock. But when did you make it? Exactly the point I was gonna uh say earlier was we should probably give some guidance on what what our I. R. S in the market right now. What are what are investors seeing? What are we seeing? Yeah. Yeah so I'll take the first tab. Um I would say if you can get mid to high teens internal rate of return on an apartment deal right now there's an unlimited amount of money you can make there's unlimited amount of money that will invest with you.

If you get mid to high teens internal rate of return on a great apartment deal you can you can fund it to the moon I would say uh they've been ir has been higher um you know for the last 10 years and they're starting to trend downward as cap rates get compressed. I would say it used to be pretty routine to get you know 2025%. I are some deals of course they hire 30 35. Even 40. Of course it's hard to sustain that type of uh return for multiple years because it's because of the compounding nature of it. But so today uh multi family is is tougher. Um I would say cash on cash is now 10 or slightly lower and I are ours now are pushing down into the mid teens. Um even it's hard to get some that are that are even high teens. It's hard to get about 15. Yeah. Right right now that's what we're seeing obviously there are some deals that are out there but we're still striving to get uh 1718 on our deals.

But it's just we haven't bought a ton of deals because it's not Easy to do when you say 1718. That's you're still talking about multi family. Right? And that multiple or are you talking about? What about retail and industrial? Are those are those I. R. S. A little higher right now because of multi family being. So they are higher definitely. But when you look at, I mean you have to be careful because you get too high on the I. R. R. And then people are asking what's wrong? You know? Well with retail it's the risk to um retail is going to be slightly higher on returns because less people are funneling capital into retail. My point is that you don't need to underwrite to an insane I. R. R. If your underwriting to a. 25 underwriting me like striving to get, I want to clarify that if you're striving to underwrite a 25 28% I. RR Then you're assuming too much risk. And I would suggest to like dial your model back a little bit, you know assume a little less risk and give a more practical return. And if you knock it out of the park and give somebody 25 and you pitch 20 good for you bro but like why set yourself up for failure.

Yeah so going back to uh I. R. Is the actual return? You only know that number when the investment has been exited. Right Okay. Everything before that is a guess based on the sponsors assumptions. So I just want to make that clarification assumptions. Yeah. Yeah because really you have to you have to know all the cash flows which means the final sale of the property and the distribution of the original investment back only then do you do you back calculate and get an I. R. Uh So to your point Brayden when talking about don't over sell the I. R. R. Investors need to understand what are the assumptions in the Ir that's being presented to me. And so how is he getting this thing cash flows? Uh X. Dollars a year. How you know maybe the cash on cash is 10 11. How are we getting to 18 average compounding yearly return over five years. Over 10 years. Well he's making he she they are making assumptions on rent growth on exit cap.

When I say exit cap, I really mean sale price uh the multiple at which your N. Y. Is trading for on the sale price. And so those are the big things that drive the I. R. The actual IR cash flow is some of it. But but all those assumptions that the exit the final exit when a lot of the money is made, that's what drives it. So that's what you got to be careful to watch and I really understand what assumptions are making. It's a good point though because you yeah I R. R. Isn't everything so I don't want people to get discouraged or you know you don't have to have a track record of successful I. R. S. What what helps is cash flow cash flow can help mitigate or help overcome your difficulties with Ir because when you're paying people A decent return 10 12% in cash flow let's say then they don't have to have the I. R. R. They're winning. They're getting cash that's that's already a win. If if you know if you're finding deals that can pay your investors enough to be happy now without waiting for some assumption that's a win for you and them you're you're not measured on the performance of your crazy guess is you know that can go in and operate with this cash flow like now.

Yeah. You know you don't have to hit it out of the park on a sale price. You want to obviously get their money back. But let's say that you broke even on the sale price you didn't sell for anymore. Well you you've been giving them 12% a year and you've been paying down that mortgage so they're gonna be they're gonna be at 13 14 15% just right there with the cash flow like I was saying earlier if someone came and pitched me a 28% I RR but I didn't get any cash flow for five years. You know that that's a little bit, it's way more risky because I have no idea what's going to happen in the future, Whether I'm getting paid 12% a year, my risk is significantly lost. Five had that that deal for 67 years. I've got almost all my money back. Yeah. Yeah. I'd much rather at the end, let's say of a 5 to 10 year deal. And all of a sudden at the end of 10 years you realize, oh, I made a 10% I. R. R. That sucks money. Just Just I wasted it for the last 10 years. But if if they're pitching something for 10 years and yeah, you're getting 10 or 12% cash on cash back, I'm I'm fine at the end. There was no more left. And all I did was make my 10-12%.

I'd, you know, I'd be disappointed, maybe I'd be okay. Yeah. And I we've had investors tell us that, you know what I mean? Um Internal rate of return is a great metric to evaluating investments um from businesses or personally, it's a great, especially great metric when used in real estate, it's really common in real estate. It's it's gonna be kind of hard to get in and talk the talk and walk the walk. If you can't really understand I. R. R. And effectively explain it to your investors. Um That's that's gonna be a big hurdle for you. So there's some good videos. This is just an intro to ir why we use it and we didn't want to get too much into the weeds. But there are videos that really go into the math of what's going on. Uh And so I I encourage people to check that out. I would also encourage you if you're listening to the podcast right now, make sure it checks out on Youtube and see our beautiful faces. We stream this just for you brian what else? Like That's it. All right guys, well thanks for joining us and hopefully we understand internal rate of return or I are a little better. All right thanks till next time, yep.


Episode #023 - A Basic Introduction to Internal Rate of Return or IRR in Commercial Real Estate!
Episode #023 - A Basic Introduction to Internal Rate of Return or IRR in Commercial Real Estate!
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