Smart investors use IRR less frequently because it has many technical flaws, but the main issue is that IRR inherently assumes the reinvestment rate is the same as the IRR itself. This implies that positive cash flows can be reinvested at the same rate, which is an unrealistic assumption, especially for projects with high IRRs.
However, in real estate investments, IRR is often used due to the sector’s stable and moderate nature. Interestingly, IRR can be broken down into its key components:
- Base return
- Return from rental growth
- Capital return – the effect of changes in the capitalization rate
Below is an example with a 10-year holding period:
The example presents an IRR of 10.3% and its breakdown into components. In the base case, rent grows by 2% annually, while the capitalization rate changes from an initial 9% to a final 10%. The capitalization rate is based on the next year’s rent and determines the property’s sale price.
- Base return – the return without rental growth or capitalization rate changes: 9%.
- Effect of rental growth – this version includes rental growth but does not account for the negative impact of the increasing capitalization rate: IRR = 11%.
- Effect of capitalization rate change – this version excludes rental growth and shows only the effect of the capitalization rate increase.
Excel File – IRR Decomposition
Source:
Commercial Real Estate Analysis and Investments, D. M. Geltner, N. G. Miller, J. Clayton, P. Eichholtz.
