What Passive Investors Need To Know About IRR
Passive real estate investors who are seeking an investment opportunity into a commercial real estate syndication have somewhat of a steep learning curve. There are a lot of terms to understand, deal structures and real estate markets to learn, as well as the investment returns that a passive investor can potentially earn with these alternative investments and the project’s projected investment performance.
Among many other terms to learn there is cap rate (capitalization rate), capital stack, NOI (net operating income), ROI (return on investment) and the COC return (cash-on-cash). But what we’ll mainly discuss in this article is what is IRR (internal rate of return), how it differs from ROI, how to calculate the IRR when examining a deal, what constitutes a high IRR or a lower IRR and why you should care about the IRR when conducting your financial analysis on a project.
Passive Real Estate Investing Myths
First, in the world of real estate it’s important that we address and debunk some myths about real estate syndications.
Myth #1: Lower Control
Some people think when you invest in commercial real estate investments through syndications that because you have less control over the asset as a passive investor that you will receive lower returns. As commercial real estate investors you are able to have full control over the ability to review the executive summary, the operating agreement, the PPM (private placement memorandum), the vetting of the deal sponsors and the analysis of the real estate market. Then, your work is done and you can sit back, relax and receive regular passive income distributions.
Myth #2: Lower Return
So, let’s also address the myth about receiving lower returns as a passive investor in commercial real estate syndications. Active investors are the deal sponsors, or the general partner in the deal. They are fully responsible for making sure that the project is successful. They are responsible for the gains and they are completely liable for the losses as well, so they have substantial risk if the project doesn’t go well.
On the other hand, as a passive investor, you’re able to capitalize on all of the benefits of investing in real estate such as tax benefits, distributions, improving communities and appreciation while also limiting your liability and being able to maintain your time freedom.
If you compare IRR among various real estate opportunities, this metric may be able to help you make a more sound investment decision.
Why Do Passive Investors Need IRR And How Does It Help?
Let’s compare the difference between IRR and ROI for example. IRR (internal rate of return) is the standard metric used to compare the return on your investment utilizing the length of time it will take for you to see your total returns. Time is part of the IRR formula. In contrast, ROI (return on investment) calculations don’t consider how long it will take for you to receive your total returns.
So, if you could invest $250K and earn $750K, is that a good deal?
Before you decide you’ll want to look at certain factors mainly the time it would take to collect that $750K because that is an important factor. If it took twenty years to receive those returns, I think I’d be less excited than if I could receive those same returns in much less time. That is the premise behind IRR – time – or the time value of money more specifically.
The other question is, what return is being reflected by that $750K? Is that an overall ROI, or is that the annualized return? The shorter the hold term, the higher the annualized ROI will be. So, you’ll want to know what factors are being calculated.
Now, if you’re trying to decide between several different investments and one is a five year hold term and another investment that is a seven-year hold term, then the ROI isn’t helpful. This is why you would need the IRR calculation so you can include the length of time your capital is invested and accurately compare the returns you might earn in each of the different properties.
Keeping It As Simple As Possible
Passive investing would be very confusing if you couldn’t compare various deals without the IRR on each deal. It looks a little intimidating, but here’s the IRR formula:
Don’t worry, though, you won’t have to do these calculations yourself if you don’t want to. Here at PCRP Group, we like simplicity. That’s why we provide the IRR calculation to our prospective investors along with a chart of other important metrics so that you can understand the projected total return and the period of time you can expect to receive your total return. This information is presented in depth in the deal’s investment summary.
Here are some fun facts: The IRR is negative until your returns equal the amount of capital you’ve invested, and then it’s 0%. After that, when your returns exceed your initial investment amount, then the percentage starts to increase beyond that 0%.
The more monthly cash flow distributions a passive investor receives in a shorter period of time, the quicker the IRR will become positive. This is why monthly distributions and early exits with the disposition of the asset are appealing to investors because these factors help to make the IRR increase more rapidly. Wouldn’t you love to double your money in a few years? I know I would!
What Variables Impact The IRR?
When you’re reviewing the executive summary, you will see a projected IRR for that project. Keep in mind, however, that it is based on the cap rate at the time of the acquisition. The IRR moves as the cap rate moves. So, we suggest that you review the financial section of the investment summary to delve deeper into the projected returns. These projections will give you an estimate of the total return based on cap rate fluctuations.
A chart similar to the example below is what you will want to review to see how the varying cap rates, among various other factors, can affect the IRR.
The asset class and the business plan designed to improve efficiencies and increase revenues also affects the expected IRR on any commercial real estate syndication investment.
Let’s take, for example, a class-A apartment syndication that is stabilized and has a 6-year term with no opportunity to refinance that could have an IRR of between 13% to 15%. Contrast that with a class B value-add apartment building that has a business strategy to exit in 5 years with a refinance opportunity and forced appreciation through a robust renovation plan that could increase the IRR into the 14% to 17% range.
Although these scenarios both reflect multifamily syndication opportunities, possibly in the same real estate market, based on all of the factors combined, you are comparing different asset classes with different strategies which will affect your projected average annual return.
A good property manager along with the direction of the general partnership team will generally try to incorporate additional revenue streams to the multifamily property by improving operational efficiencies that can affect the IRR. If the NOI (net operating income) is increased then the IRR will increase as well.
What Else To Look For When Comparing Syndication Opportunities
So what other factors should you consider? Well, you’ll want to get very clear on your investment goals, timelines, and the values that you may apply to those goals. For example, do you want to invest in only apartment complexes, or do self-storage facilities or mobile home parks or industrial properties or hotels also appeal to you and align with your financial strategy?
Each of these different asset types or the different asset classes as well as the various real estate markets will all have varying metrics as well. You’ll also want to be comfortable with your investment capital being committed to the project for the entire hold period such as three, five, or even seven years.
Another important factor to consider is the operator, of course. Do you align with their business philosophy and how they conduct their business? Do you trust them? Do they have a solid track record of success? Here at PCRP Group, first and foremost our goal is capital preservation followed by the monthly cash flow distributions then, and only then, any anticipated appreciation. These are our main goals in that order with all of our investment opportunities.
Other different metrics that any limited partner should explore further are the breakeven occupancy rate, expense ratio, loan, and debt terms as well as the deal structure being offered to the prospective investors. As a general rule of thumb, if the breakeven occupancy rate and the expense ratio are both low, then the projections are more achievable.
You will always want to conduct your due diligence on the operator as well as the project but at the end of the day, what you choose to invest in should always align with your investment goals, your values, and your risk tolerance.
Note: we are not financial advisors and are not offering financial advice of any kind. Please consult with your advisors before making any investment or financial decisions.
Ready to Learn More?
The best way for you to learn more about commercial real estate syndications is to join the PCRP Passive Investor Club.
Through the PCRP Passive Investor Club, you’ll get a priority review of all the deals we offer. We’ll work with you to determine your investing goals and then present you with the best deals to meet those goals. We’ll then guide you every step of the way as you invest in those deals.
So if you’re ready to start investing passively in institutional-grade, commercial real estate in fast-growing, climate-resilient markets in the U.S., join the PCRP Passive Investor Club – IT’S FREE! – and get started on your path to EARN PASSIVELY and LIVE ABUNDANTLY!
If you would like to know more about what we do and how it may be of value to you, please reach out to us anytime. We’re always happy to help!