What Is Considered A "Good" IRR In Real Estate?
The internal rate of return, or IRR, is one of the most heavily scrutinized return metrics in the entire real estate industry. The internal rate of return on an investment is the annualized effective compounded return rate, or the rate of return that sets the net present value of all cash flows (both positive and negative) from the investment equal to zero.
Equivalently, it’s the interest rate at which the net present value of future cash flows is equal to the initial investment, and it’s also the interest rate at which the total present value of costs (negative cash flows) equals the total present value of profits (positive cash flows). IRR also accounts for the time value of money and investments. A given return on investment received at a given time is worth more than the same return received at a later time, so the latter would yield a lower IRR than the former, if all other factors are equal.
Private equity firms raise capital with promises of certain IRR values to investors, and promoted interest, often the lifeblood of a private equity real estate shop, is going to depend on what that IRR value of a deal or fund is, and what was promised to investors when capital was first raised or the deal was first acquired.
Setting a target IRR value is one of the most important aspects of commercial real estate valuation for private equity real estate firms. But even if you’re not a huge firm and you’re just trying to decide what kind of IRR you should be shooting for on your own deals, this is still just as important.
So, to help with this process (whether your real estate investments are big or small), let’s discuss what a “good” IRR looks like in real estate investing, and how to know what that might look like in your next deal.
It’s All About Returns
Whenever an investor decides to put money in an investment vehicle, one of their biggest concerns is almost always going to be the level of risk they’re taking on in that investment, and whether the potential upside is worth the risk of loss on the deal.
In real estate, this is no different. The IRR tends to be the metric that most investors will focus on to determine if the juice is worth the squeeze on a new investment opportunity.
The internal rate of return (IRR) measures the time-weighted, annualized returns on equity invested in a deal, and includes all projected cash flows to be generated by the property over the life of the deal.
An investor’s target IRR on a real estate project is going to factor in the risk the investor is taking on at each stage of the process, and as a result, this figure is going to vary based on what that level of risk is, whether or not the investor will be taking on debt at the property, and the timing of the projected sale, as well.
So, let’s discuss this by breaking down the most common ranges for each scenario, and where each type of real estate deal might fit.
Unlevered Returns: 5%-12%
The target unlevered IRR on a real estate deal, or the target IRR without the use of debt, will generally fall somewhere between about 5% on the low end, and about 12% on the high end for most real estate deals with a projected hold period of somewhere between five and ten years.
Where the target IRR value ends up within this range is very much dependent on both the risk and projected hold period of the deal, with higher-risk projects planned to be held for a shorter period of time falling on the higher end of the spectrum, and lower-risk projects planned to be held long-term falling on the lower end of the spectrum.
An unlevered, low-risk investment opportunity minimizes investor risk of loss, and with that, investors in these deals generally are willing to accept a lower IRR as a result.
So, an appropriate target IRR for a low-risk, unlevered investment might be just 5%, while a high-risk, opportunistic project (like a ground-up development or a major asset repositioning) might need to have a target IRR of closer to 12% for investors to play ball.
Levered Returns: 10%-20%
Most commercial real estate deals are acquired with some sort of debt on the asset, so the levered IRR target is generally going to be the most relevant for real estate investors, both big and small.
The target levered IRR, or the target IRR with the use of debt, will generally be higher than the unlevered targets for that same deal, and often fall somewhere between about 10% on the low end to about 20% on the high end for that same five-to-ten year hold period mentioned in the unlevered scenario above.
Similar to the unlevered scenario, exactly where the target levered IRR value ends up within this range is very much dependent on the risk and projected hold period of the deal. Lower-risk, long-term acquisitions of new product in high demand in major gateway markets will generally see lower return expectations from investors, while higher risk, short-term acquisitions or development opportunities with business plans that require heavy lifting through a renovation or lease-up generally see significantly higher return expectations from investors as a result. For levered deals, the return expectation range tends to be bigger than in the unlevered scenario for that same deal because different debt levels magnify returns at different magnitudes.
This means that, while a low-risk deal is able to keep the risk of default low by employing a loan-to-value ratio of 30%, such a small percentage of the deal being capitalized with debt might only get that 5% unlevered IRR up to a 8% IRR on a levered basis, a relatively small increase.
On the other hand, however, a higher-risk deal might be willing to take on an additional level of default risk in exchange for higher upside on the back-end of the deal with a loan-to-value ratio of 75%, and might be able to take that that 10% unlevered IRR up to a 20% levered IRR, assuming all goes as planned on the deal.
Sale Timing And IRR Values
The IRR is a time value of money calculation. And with that, the timing of each cash flow matters a lot, and the earlier cash flows are received, the higher the IRR on a deal tends to be, all else being equal.
This means that an earlier sale date on a deal will result in an earlier return of capital, which can boost an IRR value for a 3-year hold significantly higher than the IRR for that same deal with a 10-year hold projection, even if both scenarios have very similar projected cash flows.
As a result of this, when setting a target IRR for a deal, investors will also take into account the projected hold period on the asset in question, which again increases the IRR expectations for shorter hold periods, and decreases the IRR expectations for longer hold periods.
Putting This Into Practice
The two most important factors when setting a target IRR value on a real estate deal are going to be 1) the risk profile of the deal being acquired or built, and 2) the projected hold period of the investment.
For unlevered deals, commercial real estate investors today are generally targeting IRR values of somewhere between about 5% and 12% for five-to-ten year hold periods, with lower-risk deals with a longer projected hold period on the lower end of that spectrum, and higher-risk deals with a shorter projected hold period on the higher end of the spectrum.
For levered deals, commercial real estate investors today are generally targeting IRR values somewhere between about 10% and 20% for those same five-to-ten year hold periods, with lower risk-deals with a longer projected hold period also on the lower end of the spectrum, and higher-risk deals with a shorter projected hold period on the higher end of the spectrum.
When all said and done, there’s not necessarily a “right” or “wrong” answer as far as what your target IRR should be on a given project, and different investors will view each deal differently.
If you’re looking for some guidance on a target figure you might want to set on your next acquisition or development opportunity, these are some guidelines that private equity real estate firms tend to use to value their own deals, that you can put into practice on your next investment opportunity. Should you want to have a more in-depth discussion about your opportunity or situation, reach out to the team at Realty Capital Analytics for a complementary consultation.