What is happening, BiggerPockets. This is Matt Faircloth. Here's an interesting conversation.
A lot of times people talk about a factor in evaluating real estate. There's cash on
cash return, and ROI, and cap rate, and all kinds of stuff. And these terms kind of get
blended together and they definitely get confused. But the one that gets talked about a ton is
IRR, internal rate of return. A lot of people think it's an important term, and it is, but
a lot of people think it's the only term. So when folks want to talk to me about an
apartment building deal that we're doing, first question is, "Well, what's your IRR?"
Okay, sure, we'll tell you, but there's other things to be concerned with there too, not
just what your IRR is.
I saw a deal marketed online today, and the only thing on the marketing was just what
the deal was, what the IRR was, and how to contact them. It's like, well, huh? I probably
ought to know more information than that. So IRR gets touted quite a bit. And so the
question is, what is it... we'll talk about that... and does it really matter? Because
that's an even better question as well. I've seen people quote IRRs to me on really, really
small deals. Single-family home purchase. "What's the IRR?" Well, geez, maybe it doesn't
matter there. And maybe IRR is not the only factor you should be considering when you
do a deal. IRR can be manipulated, and we'll talk about how that can be done at the end.
I don't want you guys to do it. I want you guys to watch out for folks that are manipulating
or misquoting IRR. And then we'll talk about does it matter or not. So stay to the end
to catch all that. And if you guys have questions or comments, as always, type them into the
notes below, because you know I get back to you on those things.
Let's talk about IRR and what it is, and first and foremost, what it gets confused with.
And a lot of this video was inspired by a good friend of mine, Brian Burke, because
he wrote a great book on Biggerpockets.com that you guys should pick up, called the Hands-Off
Investor. And I really think you guys should check that out, get it from Biggerpockets.com.
A link to buy it is in the notes below. Brian's a good friend of mine and it's a phenomenal
book. And it is about how to be a hands-off investor, really about how to be a passive
investor in real estate. And IRR is a huge factor when it comes to evaluating passive
real estate.
Here's a few things that IRR gets confused with that it's not. IRR is not cash on cash
return. IRR is not cap rate. Believe it or not, people confuse IRR with cap rate. They're
not the same thing. The cap rate's a means for evaluating a property's performance and
its risk factor. IRR is a whole different thing. People also confuse IRR with ROI. You're
like, "Hey, it's three letters. It's got to be the same thing, right? Maybe it means the
same thing." No. ROI is not that. It's return on investment versus internal rate of return.
These are different factors for evaluating real estate. If you guys want to be a more
savvy real estate investor and know your game when you're talking to investors, then you
may need through reading my book, Raising Private Capital, or whether you're talking
to brokers or whatever it is, you need to know the difference between all these terms.
So it's important to know.
So here's what IRR is. IRR is real simple. It is a culmination of cash flows through
the life cycle of an investment. And you sum up all those cash flows, and you look at all
the cash flows that came in during the time that you held the property, and you total
them all up, and then you average them out through the life cycle that you've owned the
property, and that's the IRR. Now let me talk to you guys about these cash flows that I'm
referring to. What's cash flow for owning a rental property? Well, hopefully it's cash
flow. And I'll just draw little buckets. The first bucket is cash flow. And cash flow is
just you have rent that comes in, you've got operating expenses, and then you've got any
debt service or whatever else you pay out, and what's left is cash flow. It's a spread
above what you charged in rent and above expenses and above debt on the property. It is the
cash that you make.
And this cash on cash return is what this relates to. So that's cash flow through the
life of the investment. And let's say you hold it for five years. The cash flow is the
cash flow you made. So if you made 5,000 a month for five years, that adds up to be...
that's $300,000. That's what that adds up to for the life cycle of the investment. So
that's cash flow.
Here's other things that we need to consider. This is one factor here that could get broken
out, but it also could get put into another bucket. I'm going to break it out. Sorry,
Brian, if you didn't want me to do that. But this is what I'm going to do. This is principle
reduction. Let's say your mortgage payment is, I don't know, $3,000 a month. Half of
that money, just for conversation, goes to pay interest. 1500 bucks. And the other half
of it, 1500 bucks, goes to pay down your mortgage. So if you're paying a $3,000 a month mortgage,
and your mortgage, the amount that you owe, your mortgage balance, is 500,000, each time
you make a payment you whittle that balance down. You nibble out a little bit.
Mortgage rates do amortize. Meaning like the more you pay that 500,000 down, the more that
ratio changes of interest or principal in your monthly payment, even the monthly payment
stays the same. What? It's true, though. You can look at an amortization table. But for
conversation purposes in this video, we're going to just keep it flat. So 1500 bucks
is the pay down of your mortgage for five years. So that is principle reduction. That
means that when you bought the property, you had a loan for this. And when you sell it,
your loan is less. That's not money in your pocket, even though, like I said, your CPA
is going to make you claim that principal reduction as income for yourself because it
is like future profit you get to make. Bottom line is you reduce that principle and you
can pull that out through a refinance of the property. Or you can realize it when you sell.
If you pull it out through a refinance, it does affect this equation. But if you take
it out when you sell, that's just another bucket of cash.
Another bucket of cash here is the sales profit. Let's say you buy a property for 500,000.
The property that's producing this cash flow got reduced in principal. Need to sell it.
And the market goes up, and you do a really good job renovating the property, and you
upkeep it and things like that. And you sell it for $700,000. So you had a $200,000 sales
profit. You had principal reduction of X amount of dollars. Let's say that's 50,000 bucks.
And you had lifecycle cash flow on the property. What you do here is you add all this stuff
up, and you look at what your initial initial investment was, X, and you obviously pay back
your initial investment. And then you look to see what rate of return you made on top
of all that, on top of all these cash flows that you have here. What rate of return did
you make through the life cycle investment through that five years.
The number you come up with here, guys, that is IRR. Because it factors in the sales profit
on the property. It factors in the principal reductions. It factors in cash flows. It even
factors in, as I said, if you refinanced the property and you kick some money back to your
investors or to yourself or whatever, that gets factored in too. All these things get
factored into the IRR. And the bottom line is the IRR is not a valid calculation to make.
It's not a real number that you even figure until you've gotten all your money back. The
IRR doesn't really kick in until you've returned all your capital. It's the profit you made
above the return of your capital through this entire cycle of investment. That's IRR.
Now, what's interesting about IRR is this is a phenomenal means to look at a hindsight
of a property. Let's say you're standing here. This is you. And you have just completed this
cycle. You had a property, you made cash flow, you had some principal reduction, and then
you sold it, and you yielded all this back to an IRR here. Very easy to calculate the
number. And you can look back on it and say, "That was an interesting deal. I made a 15%
IRR on that property through the lifecycle and the investment. Great deal." And the reason
why you can calculate that number exactly dead-on is because you have all of this information.
Because you're standing here. It's hindsight. IRR is a phenomenal hindsight tool to look
back on what you did, to find out how you did it and how you can do it again. But also
to compare, "Well, this is something I did here. Here's a rental property I was involved
in. That's IRR for this. And here is my shares of Microsoft stock. What's the IRR of that?"
You can compare investments. But IRR is best done in hindsight. And the reason for that
is that these are all known facts. If you are standing here and you're looking at it
and you're looking at a deal to get into, the problem is that there are a number of
assumptions that you have to make. You've got to assume what cash flow's going to be.
"Well, what's it going to be?" I don't know. "Well, my broker tells me I'm going to be
able to raise rents 150 bucks a unit." Well, you're pretty much going to know what principal
reduction's going to be, but what you're not going to know is, if you were to refi the
property, what are mortgage rates going to be like three years from now. What's the property
going to be worth three years from now? Are tenants going to pay the rent when I own the
property?
Well, I can assume what vacancy rate's going to be. I can assume what my expenses are going
to be. So I have to make a big A assumption here. I've got to make a big A assumption
here. Not just on principle reduction, only if I refinance it does this come in. So that's
an A.
If I'm just going to hold the property and pay it off, and if the mortgage rate doesn't
adjust, if I just am going to hold it and the mortgage rate never changes, then that's
not an assumption. But let's say I refinance it. Well, assumptions are, what's it going
to be worth, what are mortgage rates going to be, what am I going to be able to borrow
at when I do? That's an assumption. And a gargantuan assumption that's like an A the
size of this board is what am I going to sell it for years and years down the road when
I'm done, when I want to unload the property. I have to make all these assumptions.
And the way that IRR can get manipulated by investors or by folks that are presenting
deals, and Brian talks a lot about this in his book, is you can, well, okay, let's say
today's market is a 6% capitalization rate. Well, 10 years from now, when I'm going to
sell the property, Mr. Investor, I'm going to assume that cap rates are going to be exactly
the same today, 10 years from now as they are today. Come on now. That's not a real
assumption, or that's not a valid assumption, because everything can change. There could
be another COVID. There could be another whatever there is going on in the world.
10 years is a long time from now. So you've got to make some crazy assumptions on what
the world's going to be like 10 years from now, or five years from now, or one year from
now, whenever it is you're going to sell the property. So there are a number of assumptions,
and those determine your best guess, with a capital G, what the IRR is going to be.
But it is not gospel. It is not locked in on what that IRR is. And people take it as
it is.
So here is a way to evaluate a deal. When you're looking at a rental property, you're
either going to purchase, or if you're considering investing in someone's syndication or whatever
it is, look at the buckets of cash flow that they have. So if they tell you that this deal
has a 19% IRR, that's pretty attractive. It's a pretty good IRR. Well, how much of that
money that they're projecting that you're going to make on that deal is here, is coming
out of cash flow? How much of that's coming from paying the mortgage down? And how much
of that's coming out of sales?
Now, the deals that I've looked at these days, especially some of the stuff you see online,
like 90% of the profit is coming out of the sale. Like, well, you're going to make a 3%
cash on cash return while you own it. And then magically, somebody is going to sprinkle
some fairy dust on this property and it's going to sell for three times what we bought
it for, 10 years from now. And you're going to make 90% of your money. These are levers
that folks can pull or push to make IRR look higher than it actually does.
The number to really look at is cash flow. And if cash flow is somewhat similar or maybe
a little bit lower than this, and there's a nice little bump at the end on sale, and
some of the profit on sale comes from principal reduction, then you got a good deal. But you
really got to drill in to find out the assumptions that they made and where the profit buckets
are coming from when someone's calculating internal rate of return.
For more on this, like I said, read Brian's book. But the last thing I want to talk to
you guys about today is risk. Now, if I tell you, "Hey, Mr. Investor, I've got two deals
for you to pick from. Two deals I'd like for you to choose from, and which one you'd like
to invest in. This one, this deal A over here is a 12% IRR. And it's a apartment complex,
nice and stable property, everything like that, just good cash flow. Most of the money
comes from this side. A little bump on the end when we sell it, but it's going to be
a 12% IRR five-year hold. That's considered a deal.
The other deal I'd like for you to consider is going to be a 28% IRR and it's a development
deal. We're going to go build a bunch of townhomes, and we're building them in an emerging market
and we're not sure what the market's going to absorb them. But we think that the market's
going to absorb these properties really well, and they're going to sell really well. And
we think that we're going to have a nice sales at the end." Because, by the way, a development
project and not renting property could also have an IRR, because all the profit comes
here. You don't have to have cash flow and principle reduction. You could just say, "I'm
going to build a bunch of stuff and I'm going to sell it all right here." That also has
an IRR.
So let's say you compare that project. Okay, well, that's a 28% IRR and it's maybe a two
year project. Then I've got this other deal over here. It's also a rental deal, maybe
an emerging market as well. We're going to get in and we're going to get in, fix it up,
do some sprucing on it. And we sure do hope somebody's going to come on and pay us double
what we bought it for. And when they pay us double we paid for it, we're going to get
you a 19% IRR on this deal. And that's going to be a five-year hold also. Well, I'm not
trying to sway you one way or the other, but all I'm saying is look at these IRRs. If you
went on IRR only, this, oh, geez, well, this is the deal.
And what we have to consider, and what Brian talks a lot about in his book, is risk factor.
Risk factor is an enormous consideration when it comes to real estate investing. And IRR
itself does not have a risk factor associated with it. You, as the investor, whether you're
the direct operator or you're the deal provider or you're the cash provider in a deal, whatever
it is, and those are two terms that are in my book, Raising Private Capital, whichever
way you're structured as an investor, you need to consider the risk factor. Well, what's
the risk factors, like the probability that these things are going to work and that all
these numbers are going to come in, or that probability of the deal's not going to fall
apart completely, whatever it is. So the risk factor is an enormous consideration and it
is not an IRR. So that's something that you have to consider. Two big things when you're
considering a deal on IRR is what assumptions were made, and what is the risk factor.
Now, those are the considerations. Now the bottom line is, does IRR matter? Yes, it does.
It does matter. But it is not the end all be all. It is not the only thing you should
use when you evaluate a real estate project. Obviously risk factor and assumptions matter.
And also things like cash on cash return. How much are you going to make on a monthly
basis, not when the property sells? What is the cap rate on the property? Is it a 4% capitalization
rate, or is it a 15% cap rate? Why is that? Why are those cap rates different? Is it a
different riskier market? And ROI. How many times am I going to get my money back? What's
going to be my return multiplier? Things like that. Those are all factors that come in.
So IRR matters. I don't think it should be on the pedestal that people put it on as the
end all be all evaluating factor for real estate.
So I hope this helps, guys. Please ask questions, fill them up, fill them up full of questions
in the comment section. I'll gladly get back to you guys. If you guys want to see me shoot
videos or write articles on something, leave it in the comment section too because I'd
love your feedback on stuff you guys would like to see me talk about here. Thank you,
guys, for watching. I appreciate you, and have a great and profitable week.
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