
For the past few weeks, we've been talking about return metrics. Last time we talked about [Average Annual Return (AAR)](/blog/average-annual-return), and before that we discussed [Cash-on-cash return](/blog/cash-on-cash-return).

This week we'll be looking at

# Internal Rate of Return (IRR)


I’ve saved this one for last because it’s the most opaque metric. There’s quite a bit that goes into the calculation of IRR.

I’m going to cover briefly what goes into calculating IRR, but here’s the [tl;dr](https://www.merriam-webster.com/dictionary/TL%3BDR):

> **Time is money**. The closer in the future the return on your investment is, the higher the internal rate of return.

The concept of internal rate of return depends on the concept of **net present value** (NPV). Net present value is a great way to compare cash-flowing activities because it asks: _what will give me the greatest return the soonest?_

The formula to calculate NPV is:

![Net Present Value formula](https://ik.imagekit.io/knbfzwdru/IRR_2_37VrpVvTx.svg?ik-sdk-version=javascript-1.4.3&updatedAt=1652807594746)

Here’s a slightly more layman way to put that formula.

For each year:
- Take 1 plus the comparative return rate and raise it to the power of t
- Divide the return for that year in dollars by this number
- Add this new number to the sum.
  Finally, subtract any initial investment. Now you have the NPV!

We can see how this works in the table below:

![NPV Calcluation Table](https://ik.imagekit.io/knbfzwdru/IRR_1_4c9heUpBJ.svg?ik-sdk-version=javascript-1.4.3&updatedAt=1652807594596)

Since the NPV in this instance is positive, we can assume it would be a profitable venture compared to a compounding return rate of 20%.

Suppose, though, we weren’t comparing the value of this hypothetical investment to anything else? In the above example, _i_ = 0.2, but in order to find out the “absolute” value of the return of this investment over time, we’d have to solve for the value of _i_ when NPV is set to zero.

Put another way, the question we’re trying to answer is: _what rate do I need to put into the NPV formula to **reduce** my gain to 0?_ When we answer this question, we have our Internal Rate of Return.

Consider the table below that illustrates this:

![IRR Calculation Table](https://ik.imagekit.io/knbfzwdru/IRR_3_zlNQyGlZS.svg?ik-sdk-version=javascript-1.4.3&updatedAt=1652807594645)

In the case of the investment above, **the IRR is 23%**, because that’s the value of _i_ that decreases the Net Present Value to 0.

You’ll notice, though, I’m not showing my work as to how I _got_ 23% for this investment. Luckily for us, this isn’t high school math, and we can use the IRR function in Excel or Google Sheets to do this calculation.

![IRR Excel Calculation](https://ik.imagekit.io/knbfzwdru/IRR_yPgynjglw.png?ik-sdk-version=javascript-1.4.3&updatedAt=1660106898244s)

Doing an IRR calculation by hand generally involves trial-and-error (and in fact, that’s how the Excel function does it internally, only faster), so it’s worth it to use a spreadsheet program to assist in this calculation.

The bottom line in this discussion about IRR is that the **value of time** is important when comparing different investments. A dollar of ROI today is worth more than it would be tomorrow (and not because of inflation).


## Conclusion

Thank you for sticking with me! Unless you’re a data nerd (and if you are, I have a lot of respect for you) discussion of metrics is a pretty dry and dense subject.

However, by familiarizing yourself with these metrics and how they affect your return, you give yourself a big advantage: you can make more informed decisions about how your money will work best for you.


What is Internal Rate of Return?


_Want to know more about how Ursa Capital uses these return metrics to generate above-average returns for our investors? [Call or email us](/contact)!_

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In our last post, we talked about [cash-on-cash return](/blog/cash-on-cash-return), how to calculate it, and its significance as the _atomic_ ROI metric.

This time, we'll be taking a look at:

# Average Annual Return (AAR)

The average annual return is simply...the average return you make annually.

![AAR = Average(Y1, Y2...Y(n))](https://ik.imagekit.io/knbfzwdru/aar/AAR_OC2FPvJKJ.svg?ik-sdk-version=javascript-1.4.3&updatedAt=1656800349138)

But since it wouldn’t be useful for me to just restate the phrase and move on, let’s look at some examples to illustrate how it works.

## Example 1: Purchasing with cash

You buy a small apartment complex for $1M cash.
The first year, the property cash flows $75,000 (or 7.5%).

The second and third years you bump the rent a bit, and it cash flows $78,000 (or 7.8%).

After the third year, you decide to sell the property for $1M, the same price you bought it for.

![AAR = 7.63%](https://ik.imagekit.io/knbfzwdru/aar/With_Cash_ipQkS6IA_.png?ik-sdk-version=javascript-1.4.3&updatedAt=1656800431626)

Your AAR in this example is **7.63%**, because it’s the average of your return for each of those three years.

## Example 2: Purchasing with debt

In the example above, you purchased the property with 100% cash.

However, since we know that [using leverage can greatly increase return](/blog/immutable-rules-long-term-debt), let's look at what our AAR would be if we used debt on the property instead.

The purchase price is still $1M, but you put 25% down on it. The NOI is the same as above for the 3 years (75k, 78k, and 78k), but since there's a debt service to be paid on the mortgage, it only cash flows $22,387 and $26,887 for the respective years.

As we saw when looking at [cash on cash return](/blog/cash-on-cash-return), though, even though it cash flows _less, the return is significantly higher_. The cash-on-cash returns for the three years are 9%, 10.75% and 10.75%.

![AAR = 10.17%](https://ik.imagekit.io/knbfzwdru/aar/With_Debt_SEwDe9H1y.png?ik-sdk-version=javascript-1.4.3&updatedAt=1656800431963)

If we sell for the same price we bought it at, the AAR in this example is **10.17%**. 

## Example 3: Value-add with Debt
The above example is good, but a big part of [value-add investing](/blog/value-add-investing) is the **forced appreciation** that comes from raising a property's income.

This is important because

> AAR takes not only cash flow but appreciation into account.

So let's take the above example and say we can add some pretty significant value by cleaning up the property, modernizing units, and raising rents.

We're still using a loan on the property, so the first-year income is the same, giving us a 9% return.

However, through our value-add business plan, we're able to raise the revenue to $134,000, giving us a cash flow of $31,387 and a return for years two and three of **12.55%**

Now here's where it gets good. A return of 12.55% in years two and three is pretty decent, but since we plan to sell in year 3, we can _use that new NOI as the basis for its market value_.

We bought at $1M, so our [cap rate](/blog/how-are-commercial-properties-valued) is 7.5%. At that cap rate with the new NOI, the property's fair market value is $1.12M!

![48% additional return](https://ik.imagekit.io/knbfzwdru/aar/Value_add_with_debt_return_x49R3H7bU.png?ik-sdk-version=javascript-1.4.3&updatedAt=1656800430956)

If we add that 48% additional return to the year 3 cash-on-cash, we have a total year-3 return of 60.55%!

Now we can do the average:

![AAR = 27.37%](https://ik.imagekit.io/knbfzwdru/aar/Value_add_with_debt_xeET8nCUO.png?ik-sdk-version=javascript-1.4.3&updatedAt=1656800433233)

## A note on comparing returns
If you’re familiar with mutual funds, you’re familiar with this metric, as they also state their AAR historically; usually over 3, 5, and 10 year periods. Since AAR is widely used across many different types of funds, this is a great way to compare a real estate offering to other types of funds to make sure you’re getting the return you’re looking for.

At Ursa Capital, we don't look at any deal that has an AAR below 15%, which is above the [average 10-year AAR for U.S. mutual funds](https://www.thebalance.com/what-is-the-average-mutual-fund-return-4773782).

Frankly, if putting money in an ETF or a mutual fund generated a better return, I'd want investors to do that instead. But since cash-flowing real estate provides above-average returns, we have the privilege of sharing them with investors.


What is Average Annual Return?


If you hang around investors long enough, you’ll likely hear the names of metrics getting tossed around.

_(For this offering, we’re projecting an IRR of…)_

Since I come from a background in tech, I think that acronyms make everything sound cooler. Even so, they can be confusing to those who are new to the space. In this article, we’re going to cover three main **return metrics** (that is, metrics that measure the upside on a deal) and what they mean for you.

Over the next couple of posts, we'll be taking a look at what some important metrics that measure _return_ -- what you get out for what you put in.

The first of these is:

# Cash-on-Cash (CoC)

Cash-on-cash return is one of the most widely used metrics in real estate investing. Essentially, it’s the net income per year over the amount of cash invested – literally cash on cash.

![CoC Return = Profit Per Year / Amount of cash you put in](https://ik.imagekit.io/knbfzwdru/coc/1_zJtT8qhJw.png?ik-sdk-version=javascript-1.4.3&updatedAt=1657206795771)

## Examples

Let’s illustrate with an example.

You buy an investment property for $300k cash. You can rent it out for $3,500 a month and your expenses are $1,500 a month. The property therefore cash flows for $2,000 a month, or $24,000 a year.

To find the cash-on-cash return, we just plug in that yearly cash flow for the top number and our acquisition costs for the bottom number.

![$24,000/$300,000 = 8% CoC](https://ik.imagekit.io/knbfzwdru/coc/with_cash_W7HYycD7P.png?ik-sdk-version=javascript-1.4.3&updatedAt=1657206795824)

Your cash-on-cash return in this example is **8%**.

Here's another example that illustrates the power of [using financing](/blog/immutable-rules-long-term-debt).

You buy an investment property for $300k with a down payment of $60,000. The property has the same expenses as above, but you're also paying a $1,200 a month mortgage payment.

As a result, the property only cash flows $550 a month, or $6,600 a year, quite a bit less than the $24,000 a year above.

However, if we look at how much cash you put in, your return is quite a bit higher!

![$6,600/$6,000 = 11%](https://ik.imagekit.io/knbfzwdru/coc/with_financing_SVM_-EGk0.png?ik-sdk-version=javascript-1.4.3&updatedAt=1657206795838)

Your CoC return for this property with a mortgage is **11%**, even though your cash flow is decreased by the mortgage payment.

## Conclusion

Cash-on-cash is one of the most important metrics for understanding the cash flow upside to a deal, and it's the basis for the other metrics we'll discuss in this series.

You can think of it as our _atomic ROI metric_: over the next few weeks we'll build on the foundation of cash-on-cash return to get a complete picture of return.

What is Cash-on-Cash Return?


_Real estate investing is inherently risky. You can mitigate a lot of that risk by following the 3 Immutable Laws of Real Estate (credit of Joe Fairless)._

_Today we’ll be talking about_

# Rule 3: Have Adequate Reserves
Any business, including a commercial property, needs to have **reserves**. The reason for this is because of the need for **capital expenditures**, or **CapEx** for short.

CapEx purchases are made to acquire or improve existing assets. From an accounting perspective, while regular expenses like contract services, maintenance and depreciation go on a business’ income statement, capex goes on the balance sheet. For a commercial multifamily property, capex can include things like

- Putting in a new roof
- Upgrading a unit by installing new cabinets
- Building a dog park for residents

Because reserves are so important, [agency lenders](/blog/immutable-rules-long-term-debt#1-permanent-loans) generally require operators to include a deposit to reserves in a property’s expenses. Currently, the replacement reserve expense is expected to be around $250 per unit per year, but a lender could require more if the property is distressed.

We need reserves for capital expenditures, but let’s break down the two major types that we’ll need to budget for:
## 1. Capital expenditures in the business plan
These are improvements that are explicitly budgeted for as part of a business plan for an asset. Capex like this is a big part of [value-add investing](/blog/value-add-investing), because raising rents to market or reducing an expense like maintenance cost will typically involve making a capital improvement to the property.

These expenditures should be considered above and beyond the $250/unit/year reserve expense, and they’ll generally be factored into acquisition costs.

For example, if a loan requires a down payment of $1M, and it will cost $200K to refinish the units, then $1.2M plus any other closing costs would be needed from the buyer at closing.
## 2. Unexpected needs
“Anything that can go wrong, will go wrong.”

This adage, commonly associated with the engineer Edward Murphy, is known as Murphy’s law – although this idea about the universe’s cruelty toward humans originated well before him.

As you may have guessed, the reason I bring this into a conversation about reserves is because…things go wrong.

_That roof that was supposed to last another 10 years needs to be replaced now._

_You discover a problem with the HVAC system a couple years into the hold period._

_The economy has a major downturn, and residents leave or stop paying rent._

Stuff happens.

As a multifamily operator (as in my case), the last thing you want to do is go to your investors and say “something came up…I’m going to need more of your money.” Budgeting for unexpected capex and revenue shortfalls is an essential part of mitigating risk.

## Conclusion
Adequate reserves doesn’t mean throwing an arbitrary amount of cash in an account and saying “well, I hope that’s enough.” Having adequate reserves means taking a realistic inventory of what’s needed as part of an acquisition’s business plan, and what could be needed during the hold period. Doing that will help a real estate business thrive and be able to weather even the worst (literal and figurative) storms.

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Thanks for sticking with us through the 3 Immutable Rules series!

Risk is something that should be top of mind for real estate investors: not how to avoid it, but rather how to understand and mitigate it. All good things in life, including investing your money, comes with some amount of risk. I hope that now you feel better equipped to critically evaluate investment opportunities, particularly during uncertain times in the market.


Ursa Capital Blog

What is Internal Rate of Return?

What is Average Annual Return?

What is Cash-on-Cash Return?

Immutable Rule of Real Estate 3: Have Adequate Reserves