Using IRR to Select Investments

When evaluating returns on an apartment building investment, one of the most frequently used metrics is the Internal Rate of Return, or IRR. It’s a standard tool in real estate finance that allows investors to assess how efficiently capital is being used over time. While IRR provides valuable insight into the timing and scale of projected returns, it also has important limitations that any serious investor should understand.

The Strengths of IRR

At its core, IRR represents the annualized rate of return that makes the net present value (NPV) of all future cash flows equal to zero. In simpler terms, it tells you the average yearly return you can expect on your investment, taking into account when those returns actually arrive. This is what distinguishes IRR from simpler metrics like cash-on-cash return or equity multiple, which don't reflect the timing of cash flow.

For example, imagine two apartment building investments, each requiring an initial investment of $1 million and each producing $2 million in profit. In the first case, distributions are made evenly over five years. In the second, most of the return comes from a sale at the end of year five. Both deals deliver the same total profit, but the first will have a higher IRR because capital is returned more quickly. The time value of money—the idea that money today is worth more than money tomorrow—plays a critical role in IRR calculations.

This feature makes IRR particularly useful when comparing projects with different durations. Suppose one opportunity projects a 16% IRR over three years, and another shows a 13% IRR over seven years. Even if the second option generates a higher total return, the first may be more attractive if you want to redeploy capital sooner. IRR provides a way to compare these differing timelines on equal footing.

IRR is also the preferred metric among institutional investors, fund managers, and private equity sponsors. When raising capital for a real estate deal, you’re expected to present IRR alongside other indicators such as equity multiple and projected cash flow. For example, if you’re offering a 100-unit apartment project with a 15% IRR over five years and a 1.9x equity multiple, that 15% figure allows investors to quickly compare your deal with alternative investments across asset classes—whether it's a private equity fund or a corporate bond.

The Weaknesses of IRR

However, IRR has its weaknesses, and it's important to understand them. The most significant is its sensitivity to timing assumptions. If a deal model assumes a sale in year three instead of year five, the IRR could increase dramatically—even if there’s little reason to expect such an early exit. This makes it easy to manipulate the figure, whether intentionally or not. A strong IRR doesn't always mean a strong deal, especially if the assumptions behind it aren't realistic.

Another limitation is that IRR does not account for total profit in absolute terms. A project with a high IRR could yield a modest dollar return, while a lower-IRR project could produce significantly more wealth over a longer period. For instance, one investment might return $400,000 at a 20% IRR, while another delivers $700,000 at 14%. If you don’t have a better place to reinvest the capital from the first deal, the second may be the smarter long-term choice.

IRR also assumes that interim cash flows can be reinvested at the same rate as the IRR itself. This rarely reflects reality. During periods of low interest rates or limited deal flow, reinvestment options may be far less attractive. If a project forecasts annual distributions of $150,000 with an overall IRR of 17%, but those distributions end up sitting in a money market account at 4%, your actual return will be lower than the IRR implies.

Perhaps most importantly, IRR says nothing about risk. Two deals with the same IRR may carry very different levels of financial exposure. One might involve a fully stabilized property in a strong rental market with low leverage, while another might depend on heavy renovations, aggressive financing, and uncertain tenant demand. Though both deals forecast a 16% IRR, their risk-adjusted returns are clearly not equal.

Ultimately, IRR is one of the most important metrics in real estate investment analysis. It offers a time-sensitive view of return, helps compare opportunities across different timelines, and is widely used and understood by institutional and individual investors alike. However, while it provides valuable insight, IRR should never be viewed in isolation. To form a complete picture of an investment's potential, IRR must be used alongside other key metrics such as the equity multiple, which shows the total return on invested capital; cash-on-cash return, which highlights ongoing income relative to equity invested; and the overall profit, which reflects the absolute gain over the life of the project. Together, these measures give investors a more accurate sense of both return and risk. When used thoughtfully and in balance, IRR becomes a powerful part of a well-rounded investment evaluation process.