How to Analyze IRR in Commercial Real Estate (CRE)
In the commercial real estate (CRE) industry, the target IRR on a property investment tends to be set around 15% to 20%.
The investment strategies, of course, are much more diverse in the commercial real estate (CRE) industry, since properties like office buildings are purchased, rather than companies.
However, one commonality between the two industries is the reliance on leverage to fund the purchase price.
Furthermore, the hold period can last from five to ten years in the CRE industry, whereas the standard holding period in the private equity industry is between three to eight years.
But applicable to both industries, the IRR metric is the most benchmarked marketing metric to measure fund performance and an influential factor in the ability for firms to meet (or surpass) their capital raising efforts for their next fund from existing and new limited partners (LPs).
Excel XIRR vs. IRR Function: What is the Difference?
The Excel XIRR function is preferable over the IRR function as it has more flexibility by not being restricted to annual periods. Under XIRR, daily compounding is assumed, and the effective annual rate is returned. But for the IRR function, the interest rate is returned assuming a stream of equally spaced cash flows.
=XIRR(values, dates, [guess])
The drawback to the Excel IRR function is the implicit assumption that precisely twelve months separate each cell. Unlike the IRR Function in Excel, the XIRR function can handle complex scenarios that require taking into account the timing of each cash inflow and outflow (i.e. the volatility of multiple cash flows).
=IRR(values, [guess])
What Causes IRR to Increase or Decrease?
The following factors are the main contributors which drive the internal rate of return (IRR):
| Positive IRR Levers |
Negative IRR Levers |
- Earlier Extraction of Exit Proceeds (e.g., Dividend Recapitalization, Monitoring Fees)
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- Delayed Receipt of Exit Proceeds (e.g., Sale Delay Caused by Lack of Interested Buyers)
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- Increased Free Cash Flows from Strong Revenue and EBITDA Growth
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- Reduced Free Cash Flows (FCFs) and Profit Margins
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- Multiple Expansion (i.e. Exiting at a Higher Multiple than the Entry Multiple)
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- Multiple Contraction (i.e., Lower Exit Multiple than Purchase Multiple)
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Regardless, the internal rate of return (IRR) and MoM are both different pieces of the same puzzle, and each comes with its respective shortcomings.
Of course, the magnitude by which an investment grows matters, however, the pace at which the growth was achieved is just as important.
What are the Limitations to Internal Rate of Return?
The internal rate of return (IRR) cannot be singularly used to make an investment decision, as in most financial metrics.
- Timing of Cash Flows → The internal rate of return (IRR) metric is imperfect and cannot be used as a standalone measure due to being highly sensitive to the timing of the cash flows. Thus, the IRR can be misleading in its portrayal of returns under certain circumstances, wherein a greater proportion of the cash flows are received earlier.
- Shorter Holding Periods → The implied IRR from an investment could be impressively high, yet stem from the shorter holding period, which caused the returns to be artificially inflated and unsustainable if the holding period were hypothetically extended longer.
- Dividend Recap → If a private equity firm issued itself a dividend soon after a leveraged buyout (LBO), i.e. a dividend recapitalization (or recap), the payment would increase the IRR to the fund regardless of whether the multiple-of-money (MoM) meets the required return hurdles – which can cause the IRR to be potentially misleading.
IRR Calculator | Excel Template
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
1. LBO Model Entry Assumptions
Suppose a private equity firm made an equity investment of $85 million in 2022 (Year 0).
- Year 0 = –$85 million Cash Outflow
The value of the initial investment stays unchanged regardless of which year the firm exits the investment.
Since the investment represents an outflow of cash, we’ll place a negative sign in front of the figure in Excel.
2. Cash Flow Analysis Example
Afterward, the positive cash inflows related to the exit represent the proceeds distributed to the investor following the sale of the investment (i.e. realization at exit).
Here, our assumption is that exit proceeds increase by a fixed amount of $25 million each year, starting from the initial investment amount of $85 million.
- Annual Growth in Sponsor Proceeds ($) = +$25 million Per Year
Therefore, the exit proceeds in Year 1 are $110 million, while in Year 3, the proceeds come out to $160 million.
3. IRR Calculation Example
Once our table depicting the cash outflow in Year 0 (the initial investment) and the cash inflows (the exit proceeds) at different dates in the holding period is done, we can calculate the IRR and MoM metrics from this particular investment.
To determine the internal rate of return (IRR) on the LBO investment in Excel, follow the steps below.
- Start by listing out the value of all the cash inflows/(outflows) and the corresponding dates of the date of receipt
- Use the XIRR Excel function (“= XIRR (Range of Cash Flows, Range of Timing)”); the first input requires you to drag the selection box across the range of cash inflows/(outflows)
- For the second input, do the same across all the corresponding dates.
- Press Enter to Calculate the Internal Rate of Return (IRR)
For example, if the exit year is assumed to be Year 1, the IRR comes out to 29.4%.
=XIRR(G7:L7,$G$4:$L$4)
To reiterate from earlier, the initial cash outflow (i.e. sponsor’s equity contribution at purchase) must be entered as a negative number since the investment is an “outflow” of cash.
Note that for the formula to work and be dragged down, the date selection must be anchored in Excel, i.e. fixed (Press F4).
While the two main factors are the entry investment and exit sale proceeds, other inflows such as dividends or monitoring fees (i.e. the services related to portfolio company consulting) must be input as positives, as well as any additional equity injections later on in the holding period.
4. Multiple of Money Calculation Example (MoM)
In order to calculate the multiple-of-money (MoM), or multiple on invested capital (MOIC), we’ll calculate the sum of all the positive cash inflows from each holding period.
We must then divide that amount by the cash outflow in Year 0.
For instance, assuming a Year 5 exit, the exit proceeds of $210 million are divided by -$85 million to get an MoM of 2.5x.
- Multiple-of-Money (MoM) = $210 million ÷ ($85 million) = 2.5x
Therefore, the private equity firm (PE) retrieved $2.50 per $1.00 equity investment.
5. LBO Returns Analysis (IRR and MoM)
In the final section of our IRR calculation tutorial in Excel, we’ll compute the IRR for each exit year period using the XIRR Excel function.
Based on the completed output for our exercise, we can see the implied IRR and MoM at a Year 5 exit – the standard holding period assumption in most LBO models – is 19.8% and 2.5x, respectively.
- IRR – Exit Year 1 = 29.4%
- IRR – Exit Year 2 = 26.0%
- IRR – Exit Year 3 = 23.4%
- IRR – Exit Year 4 = 21.4%
- IRR – Exit Year 5 = 19.8%
If we were to calculate the IRR using a calculator, the formula would take the future value ($210 million) and divide by the present value (-$85 million) and raise it to the inverse number of periods (1 ÷ 5 Years), and then subtract out one – which again gets us 19.8% for the Year 5 internal rate of return (IRR).
