IRR (internal rate of return) Explained

If you’ve taken any economics or finance class, you have probably heard the saying, “a dollar today is worth more than a dollar tomorrow.”

What does this mean exactly?

Put simply, a dollar today allows you the ability to invest that dollar and earn a return, thereby giving you more money to invest and allow it to compound more quickly. This principle applies to real estate deals and how value-add syndications are constructed.

Take my chart for example:

You have the following two deals: A value add opportunity on an asset that can use a bit of love and rehab. On the other hand, you have a brand new 2020 built A-class apartment complex with all the best amenities.

Typically, when an operator buys an asset that needs work, their plan is to come in, renovate whatever deferred maintenance is on the property, raise rents and decrease inefficiencies on the asset, thereby increasing the NOI and ultimately, the value of the building.

On the other hand, an operator who buys a brand new stable asset is generally playing a patient game. They’re in it for the long haul. They would prefer to receive less cash flow as compared to a value add deal (see chart) in exchange for less risk and ultimately, a more valuable asset in some cases.

If you take a closer look, you will notice two things that seem to contradict themselves. In the value add deal, we see less total proceeds than in the stable deal. However, the IRR is greater. Notice that in year 3, the value add asset reached stabilization, and the sponsorship group was able to refinance and return close to 70% of their investors initial capital back into their pockets to do as they wish.

Remember, a dollar today is worth more than a dollar tomorrow. In practice, this means the sooner you get your initial investment back, the better.

However, a better IRR is not the final decision maker of a good investment. You can also look at your equity multiple. In essence, this is what amount you can expect to receive back for every dollar invested. For example, if you invested 100,000 and received $150,000 at the end of the deal cycle, that would be an equity multiple of 1.5.

When analyzing potential opportunities, it is important you look at both metrics to fully paint the entire picture and understand cash flow distribution and the sponsor’s business plan.

This topic can be confusing, and writing about it certainly helped me focus a but more on these numbers. If you have questions, please feel free to email me at