The internal rate of return – or IRR – can be an important metric in helping investors assess the potential of different investments.
However, it can also be a source of confusion for those more used to dealing with return on investment (ROI) or average annual return (ARR).
In this article, we look at what the ‘internal rate of return’ is all about, and why it matters to you as an investor.
How is IRR calculated?
The IRR is the annual rate of growth an investment is expected to generate from the time you invest right up until the point when the asset is sold – after allowing for the time value of money (in other words, a dollar today is worth more than a dollar in five years).
In this way, the IRR can be used by an investor to evaluate different opportunities.
How is IRR different from the annual rate of return (ARR) of an investment?
An important aspect of the IRR is that it considers the time value of money.
That makes it quite different from other popular indicators of returns such as the ‘annual rate of return’ (ARR), which does not take this into account.
An example here will help explain the difference.
Let’s say you purchase an investment property for $100,000. Five years later, you sell the property for $200,000. For the sake of simplicity, we’ll disregard any income the property generates during the five-year holding period.
In percentage terms, the $100,000 profit works out to a gain of 100%. If we spread that out over five years, the annual rate of return would be 20%.
The catch is that a dollar today is not the same as a dollar in five years’ time.
For instance, you may be able to buy an apple today for as little as one dollar. But in five years, a single apple could cost $1.30.
The benefits of using IRR
The ARR doesn’t take this shift in the time value of money into account. It works purely off the basic numbers.
That’s where the IRR fills the gap, as it applies a higher ‘weighting’ to funds returned earlier from an investment.
In practical terms, this means the IRR will usually be lower than the ARR.
Thinking back to the example of a property purchased for $100,000 and sold five years later for $200,000, we found the ARR is 20%. However, the IRR could be closer to 15%. This reflects how the $200,000 sale value of the asset five years down the track has less purchasing power than $200,000 today.
By capturing the time value of money, the IRR provides additional information for investors to make decisions.
Even so, the IRR does have limitations.
Factors to consider when looking at a fund’s IRR
While the IRR is useful, there are a few factors to bear in mind.
- IRR is based on estimates
An IRR is based on estimates of an asset’s future sale value and the amount of cash returned over the investment term.
However, no one knows exactly how property markets or inflation will pan out over time. And the longer the investment time frame, the harder it is to provide accurate estimates.
This makes the IRR a guide only. It is not a set-in-cement figure, though it still forms a useful part of an investor’s toolkit to weigh up different opportunities.
- A higher IRR can indicate higher risk
One of the golden rules of investing is that high returns go hand-in-hand with increased risk.
We all want to earn decent returns. But we don’t all feel comfortable taking on more risk.
This highlights the need to read the Product Disclosure Statement (PDS) or Information Memorandum (IM) of a fund to understand the risks involved and decide if it’s right for you. Don’t just focus on possible returns.
- Consider cashflow
A higher risk investment such as a property development should come with a higher IRR. After all, development projects involve more risk.
However, a higher IRR isn’t just about risk.
In a development project, it is common for the bulk of cashflow to arrive at the end of the project, generally in a lump sum, and this will reduce the IRR compared to an investment that delivers the same total amount equally over the investment term.
For some investors, though, an ongoing income is extremely attractive, and can have more personal value than a larger return earned in several years’ time.
Again, this depends on each investor’s individual needs and goals.
Why we prefer IRR as a metric
When you see a growth-based fund discussed on the Westbridge website, you’ll notice that we typically provide details of the ‘target IRR’.
This gives investors a benchmark of what to expect as a return, though it is worth stressing that this return is a target only. It is not a forecast or a guarantee, and it might not be achieved. It needs to be considered with the assumptions and risks contained in the IM or PDS for that investment.
However, it does provide a useful guide of the investment’s potential performance. The IRR also allows investors to assess the level of risk, especially when combined with information in the PDS or IM. Both can help investors decide if the fund ticks their individual boxes for an attractive investment.
For more information on the internal rate of return or any of our fund offerings at Westbridge, reach out to our team at any time via our contact form.
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