The Internal Rate of Return (IRR) is a widely used metric for evaluating investment opportunities because it provides a single number that summarizes the profitability of an investment. The IRR takes into account both the magnitude and the timing of cash flows associated with an investment, which makes it a superior method for evaluating investments compared to other metrics such as the simple payback period or the return on investment (ROI).
Relevant Templates:
- 3 IRR Hurdle Joint Venture Waterfall
- 3 IRR Hurdle Joint Venture Waterfall (with GP catch-up option)
- IRR Sensitivity Analysis - For Real Estate
One of the main advantages of IRR is that it considers the time value of money. This means that it takes into account the fact that a dollar received in the future is worth less than a dollar received today because of inflation and the potential for investment earnings. By discounting future cash flows at the appropriate rate, the IRR provides a more accurate estimate of the true profitability of an investment.
When you have a joint venture investment with IRR hurdles in place for the limited partner (LP), it is very easy for the investor (LP) to understand exactly what they should expect in terms of cash flows and when. IRR is closely tied to discounted cash flow as the IRR is equal to the discount rate you have to apply to future cash flows in order for them to be equal to the initial investment. The higher the future cash flows, the higher the discount rate that is required.
Setting the hurdle rate as an internal rate of return gives the LP a more secure notion of the value of the money returned to them and when it is returned. Looking at cash-on-cash return is fine, but it has no accounting for time and doesn't give as clear of a picture even though it is easier to calculate and understand. It is not a better evaluation tool.
Both IRR and cash-on-cash look at the cash in and out of the deal, but IRR is a better tool to look at the entirety of the life of the investment. Setting the 'hurdle goal' as an IRR means the LP knows that no matter how long it takes to get their return, the amount returned must reach the hurdle rate defined before any GP promotions or other cash distributions happen. This makes huge difference compared to just a simple return with simple non-compounding interest. If you are the LP, you want IRR hurdles.
IRR accounts for the reinvestment of cash flows. When evaluating an investment, it's important to consider what you will do with the cash flows generated by that investment. IRR assumes that cash flows are reinvested at the same rate as the project's initial rate of return, which provides a more accurate picture of the investment's potential return.
Finally, IRR is a flexible metric that can be used to evaluate a wide range of investment opportunities, including projects with varying cash flows and project durations. It is also easy to calculate using spreadsheet software or financial calculators, making it a widely accessible and practical tool for investors.
As long as you can calculate the periodic cash outflow and inflow, you can calculate IRR. It is easy to do in Excel or Google Sheets with the IRR or XIRR functions and easily convert monthly periods to annual and vice versa.
Overall, the IRR is a superior metric for evaluating investments because it considers both the magnitude and timing of cash flows, accounts for the time value of money and the reinvestment of cash flows, and is a flexible and practical tool for investors.
Here is more info about IRR Hurdles and real estate investment.
