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IRR COMPARED TO ROI
Most Australian real estate investors understand Capital Growth, Compound Growth and rental return or rental yield, but unless they have invested in Commercial Real Estate before, or are financial professionals, may not know the term IRR (Internal Rate of Return).
Return on Investment, usually abbreviated as ROI, is a common, widespread metric used to evaluate the forecasted profitability on different investments. Before any serious investment opportunities are even considered, ROI is a solid base from which to go forth.
The metric can be applied to anything from stocks, real estate, employees; anything that has a cost with the potential to derive gains from can have an ROI assigned to it.
While much more intricate formulas exist to help calculate rate of return on investments accurately, ROI is lauded and still widely used due to its simplicity and broad usage as a quick-and-dirty method.
The internal rate of return (IRR) on an investment or project is the "annualized effective compounded return rate" or rate of return that sets the net present value of all cash flows (both positive and negative) from the investment equal to zero.
Simply stated, the Internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested.
Ultimately, IRR gives an investor the means to compare alternative investments based on their yield.
Speaking intuitively, IRR is designed to account for the time preference of money and investments. A given return on investment received at a given time is worth more than the same return received at a later time, so the latter would yield a lower IRR than the former, if all other factors are equal.
A fixed income investment in which money is deposited once, interest on this deposit is paid to the investor at a specified interest rate every time period, and the original deposit neither increases nor decreases, would have an IRR equal to the specified interest rate.
An investment which has the same total returns as the preceding investment, but delays returns for one or more time periods, would have a lower IRR.
Generally speaking, the higher an internal rate of return, the more desirable an investment is to undertake. IRR is uniform for investments of varying types and, as such, can be used to rank multiple prospective investments or projects on a relatively even basis. In general, when comparing investment options with other similar characteristics, the investment with the highest IRR probably would be considered the best.
Mathematically, the IRR can be found by setting the Net Present Value (NPV) equation equal to zero (0) and solving for the rate of return (IRR).
If If the above equation scares you don’t worry, we will walk through a detailed example next that shows you exactly and it will leave you with a solid intuition behind the internal rate of return.
The mathematical (and typical) explanation of IRR as “the discount rate that makes the net present value equal to zero.”
While technically correct, that doesn’t exactly help us all that much in understanding what IRR actually means. Once you break it out into its individual components and step through it period by period, this becomes easy to see.
The calculation below shows the the IRR of an investment over 4 years with a simple lump sum investment, and no dividends paid out, and no further capital invested over the term.
The IRR was calculated at 20% and the Tax rate was calculated as being a flat 30%.
ROI maybe confused with ROR, or rate of return.
Sometime, they can be used interchangeably, but there is a big difference:
ROR can denote a period of time, often annually, while ROI doesn't.
The basic formula for ROI is: ROI = Gain from Investment - Cost of Investment Cost of Investment
As a most basic example, Bob wants to calculate the ROI on his real estate investment. From the beginning until present, he invested a total of $500,000 into the project, and his total profits to date sum up to $700,000.
$700,000 - $500,000/ $500,000 = 40%
Bob's ROI on his property investment is 40%.
Difficulty in Usage
It is true that ROI as a metric can be utilized to gauge the profitability of mostly anything. However, its universal applicability is also the reason why it tends to be difficult to use properly.
While the ROI formula itself may be simple, the real problem comes from people not understanding how to arrive at the correct definition for 'cost' and/or 'gain', or the variability involved.
For instance, for a potential real estate property, investor A might calculate the ROI involving capital expenditure, taxes, and insurance, while investor B might only use the purchase price.
For a potential stock, investor A might calculate ROI including taxes on capital gains, while investor B may not. Also, does an ROI calculation involve every cash flow in the middle other than the first and the last? Different investors use ROI differently.
However, the biggest nuance with ROI is that there is no timeframe involved. Take for instance, an investor with an investment decision between a diamond with a ROI of 1,000% or a property with an ROI of 50%.
Right off the bat, the diamond seems like the no brainer, but is it truly if the ROI is calculated over 50 years for the diamond as opposed to the property's ROI calculated over several months?
This is why ROI does its job well as a base for evaluating investments, but it is essential to supplement it further with other, more accurate measures.
The ROI Calculator includes an Investment Time input to hurdle this weakness by using something called the annualised ROI, which is a rate normally more meaningful for comparison.
When comparing the results of two calculations computed with the calculator, oftentimes, the annualised ROI figure is more useful than the ROI figure; the diamond versus land comparison above is a good example of why.
In real life, the investment risk and other situations are not reflected in the ROI rate, so even though higher annualized ROI is preferred, it is not uncommon to see lower ROI investments are favored for their lower risk or other favorable conditions.
Let’s walk through a detailed example of IRR and show you exactly what it does, step-by-step.
(Source: Property Metrics)
Suppose we are faced with the following series of cash flows: This is pretty straightforward.
An investment of $100,000 made today will be worth $161,051 in 5 years. As shown the IRR calculated is 10%.
This is also, simply the average annual compound growth, which most real estate investors are very familiar with.
Now let’s take a look under the hood to see exactly what’s happening to our investment in each of the 5 years:
As shown above in year 1 the total amount we have invested is $100,000 and there is no cash flow received.
Since the 10% IRR in year 1 we receive is not paid out to us as an interim cash flow, it is instead added to our outstanding investment amount for year 2 and so on until year 5.
Exactly as with a typical property investment. There is nothing complicated at all about this.
Notice how this lump sum payment includes both the return of our original $100,000 investment, plus the 10% return “on” our investment.
As shown above, the IRR is clearly the percentage rate earned on each dollar invested for each period it is invested. Once you break it out into its individual components and step through it period by period, this becomes easy to see.
What IRR is Not
IRR can be a very helpful decision indicator for selecting an investment.
However, there is one very important point that must be made about IRR:
it doesn’t always equal the annual compound rate of return on an initial investment. Let’s take an example to illustrate.
Suppose we have the following series of cash flows that also generates a 10% IRR:
In this example an investment of $100,000 is made today and in exchange we receive $15,000 every year for 5 years, plus we also sell the asset at the end of year 5 for $69,475. The calculated IRR of 10% is exactly the same as our first example above.
But let’s examine what’s happening under the hood in order to see why these are two very different investments:
As shown above in year 1 our outstanding investment amount is $100,000, which earns a return on investment of 10% or $10,000. However, our total interim cash flow in year 1 is $15,000, which is $5,000 greater than our $10,000 return “on” investment. That means in year 1 we get our $10,000 return on investment, plus we also get $5,000 of our original initial investment back.
Now, notice what happens to our outstanding internal investment in year 2. It decreases by $5,000 since that is the amount of capital we recovered with the year 1 cash flow (the amount in excess of the return on portion).
This process of decreasing the outstanding “internal” investment amount continues all the way through the end of year 5. Again, the reason why our outstanding initial investment decreases is because we are receiving more cash flow each year than is needed to earn the IRR for that year.
This extra cash flow results in capital recovery, thus reducing the outstanding amount of capital we have remaining in the investment. Why does this matter? Let’s take another look at the total cash flow columns in each of the above two charts.
Notice that in our first example the total $161,051 while in the second chart the total cash flow was only $144,475.
But wait a minute, I thought both of these investments had a 10% IRR?!
Well, indeed they did both earn a 10% IRR, as we can see by revisiting the definition or IRR:
The Internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested.
The internal rate of return measures the return on the outstanding “internal” investment amount remaining in an investment for each period it is invested.
The outstanding internal investment, as demonstrated above, can increase or decrease over the holding period.
It says nothing about what happens to capital taken out of the investment.
And contrary to popular belief, the IRR does not always measure the return on your initial investment.
The Myth of The Reinvestment Rate Assumption
One of the most commonly cited limitations of the IRR is the so called “reinvestment rate assumption.”
In short, the reinvestment rate assumption says that the IRR assumes interim cash flows are reinvested at the IRR, which of course isn’t always feasible.
The idea that the IRR assumes interim cash flows are reinvested is a major misconception that’s unfortunately still taught by many business school professors today.
As shown in the step-by-step approach above, the IRR makes no such assumption.
The internal rate of return is a discounting calculation and makes no assumptions about what to do with periodic cash flows received along the way.
It can’t because it’s a DISCOUNTING function, which moves money back in time, not forward.
This is not to say the the IRR doesn’t have some limitations, as shown in the examples above. It’s just to say that the “reinvestment rate assumption” is not among them.
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