Why IRR is Not the Rate of Return for Your Investment: Introducing AIRR to the Real Estate Community
23 Pages Posted: 30 Apr 2011 Last revised: 3 Jul 2016
Date Written: December 4, 2011
The internal rate of return (IRR) is used extensively in the real estate sector, notwithstanding certain nagging deficiencies taught in most business school texts. One of those deficiencies is that the IRR may have multiple solutions which cannot be reconciled. Unbeknownst to most practitioners, this “nagging deficiency” has been refuted in the last decade, seemingly great news for IRR advocates. However, the elimination of this deficiency exposes a more fundamental criticism, one which is addressed in this article; and it is that the IRR calculation itself assumes interim investment values that are mechanically generated by the IRR equation itself and will almost surely differ from the true interim values of the project under consideration. To the extent that these values differ, the IRR result will not be an accurate rate of return. Furthermore, from an ex-post, i.e., performance reporting standpoint, such values implied by the IRR will almost certainly contradict any estimated project values being used for time-weighted rate of return (TWR) purposes. A new metric called AIRR (Average IRR) overcomes these criticisms and produces a correct money-weighted rate of return (MWR) for a project. Furthermore, AIRR has none of the other problems that the IRR has: e.g. it always exists and is unique, and it appropriately accounts for the amounts actually invested, from time to time, over the course of the investment.
Keywords: real estate, internal rate of return, average, interim capital
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