Evaluating Investment Properties in Nigeria: Internal Rate of Return (%).
It is easier to monitor the performance of investments like stocks and bonds because on any given day, investors can log onto financial news websites or check their brokerage accounts to see how their holdings are performing. Fortunately, in the case of a real estate investment this requires a bit more work as this asset class is somewhat private and doesn’t afford the same daily visibility into pricing and performance.
In light of this, one of the most commonly accepted ways to gauge the profitability of a real estate investment is by calculating its Internal Rate of Return (IRR).
What does IRR (Internal Rate of Return) mean?
According to Cadre Insights* “the Internal Rate of Return (IRR) is a metric that tells investors the average annual return they have either realized or can expect to realize from a real estate investment over time, expressed as a percentage”.
In more simple terms, the Crowdstreet blog** defines the IRR as “the rate at which a real estate investment grows (or, heaven forbid, shrinks). In this sense, you can think of it as a time-sensitive compounded annual rate of return”.
The intuition behind IRR is to combine a measure of both profit and time into a single metric;
- First is the concept of profit: how much cash an investment generates relative to the amount you invested.
- Second, time value of money: a somewhat more complex concept, but simply accounts for how Inflation affects the value of money over time, meaning a Naira today is worth more than a Naira five years from now. For instance, N100 today may only have N50 of buying power in 2024.
Also, every investment has a trade-off, or what is called “opportunity cost”. If you chose to invest in Yaba, it may mean you are forgoing the opportunity to invest in Surulere. Or, if you receive a Naira today, you could invest that Naira and earn a return, but if you receive that Naira in the future instead of immediately, you are missing out on a potential return now. Let me show with an example that makes me understand this better.
How real estate investors can use IRR.
The IRR is useful because it can provide an “apples-to-apples” comparison of two cash flows with different distribution timing. Over the duration of a real estate investment, which typically lasts for at least a few years, investors will either receive a series of interim payments from renters or receive no payment at all, and finally receive larger lump sum once a property is sold.
The IRR also helps investors compare real estate investments to other investment opportunities.
Because these cash flows occur over many months or years, their relative value isn’t equal and this is how investors can know profitability of that property and compare with other properties or other investment options.
It is important to note that for most real estate investments, the initial IRR is only an estimate based on a number of assumptions. However, it is still a valuable tool for measuring an investment property’s annualized return. Once the investment is sold, the actual final IRR can then be calculated.
Investors also should not use IRR alone to evaluate deals but use other metrics like the Cap Rate and equity multiple(coming soon).
Why a larger IRR isn’t always the goal.
It is often said that the bigger the better (e.g. a 14% IRR is better than a 10% IRR) but for investments generally other factors play key roles.
While a bigger IRR might look good at face value, it is important for investors to take into consideration the size or risk profile of the property, the time frame over which that return will be generated, or the actual Naira amount of profit to be realized (i.e Total return/profit). Real estate investments can also carry risks that can be difficult to accurately project, such as rental rates and occupancy.
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