Why IRR Is an Essential Metric for Multifamily Investors

Internal rate of return (IRR) is a financial metric commonly used to evaluate the profitability of an investment. It measures the annual return that an asset is expected to generate, expressed as a percentage. 

In the context of multifamily real estate, IRR is an essential consideration for investors because it allows them to compare the potential returns of different investment opportunities and make informed decisions about where to allocate their capital. 

There are also several factors that can affect the IRR of a multifamily investment. These include the size of the acquisition, the length of the holding period, the level of debt financing used to fund the investment, the rental income generated by the property, and the expected appreciation in the property's value over time. 

Benefits of Using IRR

One of the key benefits is that an IRR considers the timing of cash flows. Unlike other financial metrics, IRR assumes that money received in the future is worth less than money received today due to the time value of money. This assumption makes IRR a more accurate measure of the true profitability of an investment, as it accounts for the fact that an investor will not receive all of the cash flows from an asset simultaneously.

Another significant benefit of using IRR to evaluate multifamily investments is that it allows investors to consistently compare the returns of different assets. For example, suppose an investor is considering two other multifamily properties. They can use IRR to determine which one is likely to generate the highest return, regardless of the investment's size or the holding period's length.

Factors That Can Impact IRR

Leverage

One factor that can impact IRR is the level of debt financing used to fund the acquisition. In general, the use of leverage (i.e., borrowing money to finance the purchase of the investment) can increase the IRR of an asset, as it allows investors to generate a higher return on their equity (i.e., the amount of money they have invested). 

However, it is essential to note that the use of leverage also increases the risk of an investment, as the investor is more exposed to changes in interest rates and the borrower's creditworthiness. 

Rental Income

Another factor that can impact the IRR of a multifamily investment is the rental income generated by the property. In general, properties that can create higher levels of rental income are more likely to have a higher IRR, as they can generate a more significant return on the investment. Factors that can influence rental income include:

• The location of the property
• The quality of the property
• The demand for rental units in the area

Expected Appreciation

Finally, the last factor that can impact the IRR for multifamily investments is the expected appreciation in the value of the property. In general, properties that appreciate over time are more likely to have a higher IRR, as the investor will be able to sell the property for a higher price in the future. Factors that can impact the appreciation in the value of a property include:

• Economic conditions
• The overall strength of the real estate market
• The location of the property

How to Calculate the IRR for a Multifamily Project

The cash flow generated over the project’s lifetime must be estimated. These cash flows include any income from rent or other sources and any expenses such as property taxes, insurance, and repairs. 

You can use a spreadsheet program such as Microsoft Excel to calculate the IRR using the following steps:

1. Estimate the cash flows for the multifamily project over its lifetime. These cash flows should include all expected income and expenses.
2. Determine the initial investment in the project. The initial investment is the amount of money that will be needed to get the project started.
3. Calculate the net present value (NPV) of the investment using the estimated cash flows and the initial investment. To do this, use a discount rate that approximates the expected return on investment.
4. Use the NPV function in the spreadsheet program to calculate the IRR. This function will take the initial investment and the estimated cash flows as inputs and return the IRR as the output.
   

Conclusion

In conclusion, IRR is an important consideration for investors in multifamily real estate, as it allows them to compare the potential returns of different investment opportunities and make informed decisions about where to allocate their capital. 

Factors that can impact the IRR of a multifamily investment include the size of the acquisition, the length of the holding period, the level of debt financing used to fund the investment, the rental income generated by the property, and the expected appreciation in the value.

About the Author:

Veena Jetti is the founding partner of Vive Funds, a unique commercial real estate firm that specializes in curating conservative opportunities for investors.