Surprisingly, perhaps, Internal Rate of Return (IRR) requires a great effort to understand. A cherished metric by the Asset Management Industry to briskly calculate carried interest and management fees, IRR tends to overstate the short-term profitability at the expense of the long-term profitability.
Conundrum surfaces if the first project is preferable using IRR methodology while a second project is preferable using NPV methodology. Let us walk through a demonstration.
First acquisition potential is a class C office building located in a subpar neighborhood. To see its potential, the acquirer would probably have to possess two left-brain qualities: creativity and imagination. It lists for one million, and year 1 to year 3 after-cash flow are $50,500. With a required rate of return of 10 percent, Net Present Value (NPV) is $256,000 and IRR is 24 percent.
Second potential purchase is an industrial warehouse. Located in Corona, CA, and anchored by Loew’s, the 115,000 SF building was built in 2005. Asking purchase price is $11 million and expected year 1 to year 3 cash flow is $500,000. Using the same time horizon as the office building, NPV is $1,434,000 and IRR is 17 percent.
Which project is preferable? Assuming both properties have similar risk characteristics and the investment budget allows purchasing either the first or the second properties, it may help to look into the Differential Cash Flow.
Differential Cash Flow is the added cost of purchasing the industrial building. The hypothetical investment would have a cost of $10 million; its annual cash flow would be $449,500. The NPV on the incremental investment is $1.178 million. Because the expected return is higher than the required return, the industrial building provides a greater return than the office building.
While a different purchase price may result in contrasting IRR and NPV decisions, even with an equal purchase price, the NPV and IRR ranking may vary if the cash flow patterns are different.
To choose Project B over Project A because it offers a higher IRR would be incorrect. For every dollar invested, Project A returns a dollar and 40 cents while Project B returns a dollar and 30 cents. In absolute terms, despite the lower IRR, Project A offers additional $90,000 in after tax cash flow.
Joe Stampbone, of Atlas Real Estate Partners, further writes about the assumptions embedded in the IRR calculation. In an article titled Returns Metrics that Matter When Underwriting a Potential Real Estate Investment, he explains that the IRR assumes that positive cash flow will be reinvested in the building, and that this cash flow will yield a return equal to the IRR.
In a declining interest rate environment, it is a questionable assumption.
In short, as a favorite investor once wrote, “Common yardsticks such as dividend yield, the ratio of price to earnings or book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flow into and from the business.”