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## The Case of the Mysterious Sinking IRR

Users of our Real Estate Investment Analysis program sometimes call us with questions that are not about the software but about the underlying analysis. If we had a “greatest hits” list for those questions the all-time winner would be this: “My cash flow goes up each year; the value of the property goes up each year; but when I look at the Internal Rate of Return, it goes down almost every year. What’s up with that?” To see how this can happen, let’s take a look at two very simple examples.

Example #1: We purchase a property for \$100,000 all cash. It has a Net Operating Income of \$10,000, so the capitalization rate is 10%. We are going to assume that 10% is the right cap rate for this market (primarily because it make the math in our example easy to follow). Because we bought the property for cash there is no debt service and so we can also assume that the cash flow is the same as the Net Operating Income. For those who require an instant (and very abbreviated) refresher course on these concepts, use the following:

• Gross Income less Operating Expenses equals Net Operating Income
• Net Operating Income less Debt Service equals Cash Flow
• Net Operating Income divided by Capitalization Rate equals the property’s Present Value

The property is in good shape and is running well when we buy it. Our initial cash flow occurs on Day One when we spend \$100,000 in cash to make the purchase. We project that we can raise the rent 4% during the first year to \$10,400. The property is well-located, so we believe we can get a bit more aggressive over time. We’ll project that we can increase the revenue 5% in the second year, 6% in the third, 7% in the fourth and 8% in the fifth. Here is what our projections look like:

Notice that, if we sell the property at the end of one year for its full value (i.e., with no selling costs, to keep matters simple), our Internal Rate of Return (IRR) is a pleasing 14.4%. If we sell at the end of year two, our IRR for that holding period is even better, 14.92%. If we hang on to the property for five years, we see that we can expect a 16.38% IRR. The rents go up each year, the value goes up and so does the IRR. All is right with the world.

Example #2: At the same time we buy another property, also for \$100,000 cash. It too has a \$10,000 NOI, but this property needs immediate management improvements to control expenses and to get rents in line with the market. We feel sure that we can get the NOI (and hence the cash flow) to \$12,000 in the first year. That should get it on a stable footing, from which we expect a more modest 3% increase in rent each year thereafter. The rents go up each year, the value goes up each year, but what about the IRR?

At the end of the first year, we’re thrilled by a robust IRR of 32%. We worked hard; we deserve it. But if we hold the property for a second year the Internal Rate of Return drops to 22.76% — still not shabby but significantly lower than at the end of the prior year. Indeed, the longer we hold the property, the lower the IRR becomes. What, to coin a phrase, is wrong with this picture? Nothing is wrong, actually. The numbers are correct. Remember that Internal Rate of Return is a time-sensitive measurement. The biggest jump in cash flow and in the property’s value came early. The earlier it arrives, the less severely it gets discounted — it’s the “time value of money” concept. The increases that occur in years two through five are smaller to begin with and they get discounted over a greater number of years, shrinking their worth to us today even more.

Simply put, if we hold the property two years instead of one, then that second year dilutes the overall rate of return because it didn’t contribute as much (especially after an extra year of discounting) as the first year did. If we hold the property for three years, the return gets diluted still further.

At this point, someone in the back of the room is surely asking the insightful question, “So what?” Here’s what: The first property is telling us that it will perform better as an investment if we hold onto it for a while. Its rent increases are accelerating each year. Even though the increases have to be discounted — it’s that time value of money again — they’re growing at a pace that makes them worth waiting for. Hence the IRR gets higher with each year we hold on. The second property, however, has a bit more of a roman candle quality to its performance. The big flash comes early; after that, it just sputters along.

Does this mean you should immediately sell such a property? If you’re happy with the long-term IRR and could not find a replacement property with a greater yield, it might make sense to hold. Or you might be more comfortable following the words of immortal Janis Joplin: Get it while you can. To put that in more businesslike terms, you might decide to sell the property when the IRR peaks; then take the proceeds and reinvest them. Whichever way you go, the important thing is that you’ll be making an informed decision.

Better than being like this guy.

If you found this example helpful, I have a lot more educational material for real estate investors and developers. For example, check out these video lessons…

Real Estate Investment Case Studies where I take you step-by-step through the evaluation of five different property types: apartment, mixed-use, triple-net leased, retail strip center, and single-family property

Value-Add Real Estate Investments where I show how you might do something tangible or intangible to a property, but in either case, something that increases how much a person would pay to acquire that asset from you when you’re done.

Or if you’re ready for a complete training series in real estate investment, development, finance, partnerships, and more, consider Mastering Real Estate Investing.

—— Frank Gallinelli

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

## Educating Real Estate Investors — Third Episode in My New Podcast Series

Welcome back to my new podcast series. In my first interview I answered some questions about how I got started as an investor, and I hope my experience provided some ideas for you if you’re just looking to get started yourself.

And in the second, I talked about my first commercial investment, which is where I really found my way in leveraging technology, and which led to the birth of RealData software.

In this third interview I discuss how my experiences with the software company evolved into a passion for investor education.

Below is a snippet of the video version of this podcast. You can watch the entire video on youtube, or visit our complete youtube video library (lots of good stuff there for investors). You can also listen to the audio version of my podcasts on Spotify, Apple, or on most anyplace you usually get your podcasts.

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

## Evaluating an Income Property and the Birth of RealData — Second Episode in My New Podcast Series

Welcome back to my new podcast series. In my first interview I answered some questions about how I got started as an investor, and I hope my experience provided some ideas for you if you’re just looking to get started yourself.

Now I want to take you on the next few steps in my journey and talk about how I came to learn about analyzing income-property investments.

In this interview I tell you about my first commercial investment, which is where I really found my way in leveraging technology, and which led to the birth of RealData software.

Below is a snippet of the video version of this podcast. You can watch the entire video on youtube, or visit our complete youtube video library (lots of good stuff there for investors). You can also listen to the audio version of my podcasts on Spotify, Apple, or on most anyplace you usually get your podcasts.

#### UPDATE: Episode 3 is available now!

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

## Getting Started in Real Estate Investing — First Episode in My New Podcast Series

You probably all know me as a “numbers guy” who focuses on metrics and analysis of potential real estate investments.

But I hear lot of people who sound frustrated or discouraged by a very basic question: Just how do I get started?

So I’m going to step back from my spreadsheets for a bit and try to address that question — and I’ll do it in this first of a series of podcasts where I’ll talk about the not-so-exotic way I began. Spoiler alert: I’ll discuss something I did back then that I didn’t know had a name, something called BRRRR.

The video below is a snippet from the first podcast. You can listen to the whole thing on Spotify, Apple, or on most anyplace you usually get your podcasts.