Internal rate of return (IRR) is a discount rate that makes the net present value of all projected cash flows from an investment, including the eventual sale proceeds, equal to zero. Unlike simpler metrics like cap rate or cash-on-cash return, IRR accounts for the time value of money across a full projected holding period, incorporating both ongoing cash flow and the eventual disposition value.
Why IRR captures more than simpler return metrics
IRR incorporates the timing and magnitude of every projected cash flow over an investment's full holding period — annual cash distributions, any refinancing proceeds, and the ultimate sale price at exit — discounted back to present value. This makes IRR particularly useful for comparing investments with different holding periods, cash flow patterns, or exit assumptions, since it standardizes returns on a time-adjusted basis.
What to watch for before committing
Exit value assumption realism
Scrutinize the assumed exit sale price and cap rate used in an IRR projection, since this significantly affects the calculated return and is inherently uncertain.
Holding period assumption
Understand the specific holding period assumed in the IRR calculation, since changing this assumption can meaningfully affect the result.
Cash flow projection accuracy
Verify the underlying annual cash flow projections feeding into the IRR calculation are realistic, not overly optimistic.
Sensitivity analysis
Consider running sensitivity analysis with different exit cap rate or holding period assumptions to understand the range of potential IRR outcomes.
Leveraged vs unleveraged IRR
Confirm whether a cited IRR reflects leveraged or unleveraged returns, since financing significantly affects the outcome.
Comparison across investment options
When comparing multiple opportunities by IRR, ensure consistent methodology and assumption rigor across all projections.
When you need to know this
- Evaluating a multi-year investment hold — assessing total return accounting for the time value of money
- Comparing investments with different holding periods — using a standardized, time-adjusted metric for comparison
- Underwriting a value-add or development project — incorporating projected cash flow growth and eventual exit value
- Evaluating sponsor or fund investment projections — critically assessing the assumptions behind a projected IRR
Frequently asked questions
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