Among real estate financial analysts, there are those who prefer the Internal Rate of Return (IRR) and those who prefer Net Present Value when assessing the viability of a potential acquisition. When my clients ask me which measure I prefer, my response is always “Neither”.
Many financial analysts, real estate focused or otherwise, accept that there are limitations inherent with both measures, but will still use these measures as most of their lenders, equity investors, or partners “expect” that these return measures will be part of the investment decision.
However, before delving into the reasons I don’t rely on either IRR or NPV for my real estate decisions, a brief discussion each is warranted.
The IRR is, simply put, the discount rate (expressed as a percentage) at which the net present value of an investment becomes zero. Typically, the advantage of using the IRR is that it allows for an easy comparison between investment alternatives with an option offering a higher IRR being preferable to an option with a lower IRR.
However, when choosing an option with a higher IRR, you may actually be choosing an option with a lower real rate of return. Although it seems improbable, real returns can be distorted because of the most dangerous assumption inherent in IRR calculations, this being that interim cash flows will be re-invested at the same high rates of return. The IRR is only truly accurate when an asset generates no interim cash flows, or when those interim cash flows can actually be re-invested at the actual IRR. As such, in most instances the IRR will be distorted, and in many cases, significantly so.
NPV is similar to IRR in some respects in that they both factor in the “time value of money”. Specifically, the NPV is the difference between the present value of cash in-flows and the present value of cash out-flows that occur as the result of investing in a cash producing asset like real estate.
This number can be negative, positive or zero. As one would expect, an opportunity with a negative NPV would be viewed as one to avoid. Also, a neutral or zero NPV should also be viewed somewhat negatively, as if the opportunity has any risk whatsoever, it would be preferable to simply do nothing. Of course, an investment with a positive NPV may be considered attractive based upon risk/reward assessment.
However, like the IRR, the NPV method suffers from a critical deficiency. The biggest drawback to the calculation of NPV is its reliance upon a discount rate. As NPV computations are simply a summation of multiple cash flows, the discount rate chosen used to calculate the final NPV is critical to an accurate assessment. The problem is that in these calculations, the discount rate is arbitrarily chosen, and differing discount rates, even those that only differ slightly, can have a significant effect on the final output.
So, if both the Internal Rate of Return and Net Present Value both include inherent deficiencies that can produce misleading results, what rate of return measures, if any, can be used to assess the viability of a real estate investment opportunity? While every return measure offers at least some limitations, there are those for which those limitations are minor, and I will address these items specifically in my next article.