Why the IRR is a lousy metric for Investors

Often when someone comes to you pitching an investment, they're going to show you a big shiny IRR to grab your attention. (If you’re new here, see my article: “What is an IRR? And why does it matter?”) The conversation often revolves around the impressive-looking return that the IRR represents. On the surface, it seems straightforward: a higher IRR means a better deal, right? Or, in the timeless words of one of my friends: “Bigger numbers is gooder numbers”. Well, not so fast.

The problem with IRR as a metric is that it’s heavily influenced by the timing of cash flows. A project that generates significant returns early will show a much higher IRR than one with equally strong returns spread out over a longer period. This quirk makes it easy to manipulate. For example, if a sponsor sets their exit (sale of the asset) in Year 3 instead of  Year 5, the IRR can swing dramatically—even if the total profit remains unchanged.

Another flaw in IRR as it relates to Real Estate deals is that it can easily be manipulated by simply cranking up the Terminal Value (at the time you go to sell the asset). If the majority of your overall returns are created by that sale, and not by the recurring annual cashflow, then the IRR will magically rise. Predicting the Terminal Value in 5 years’ time is literally a guessing game, as there are multiple market forces that will change in that period of time.

In fact, I can tell you that 100% of all projected IRR’s do not materialize. The final return at the end of a project is always either higher or lower than the predictions. As Yogi Berra told us; “It’s tough to make predictions, especially about the future”.

Additionally, the IRR doesn’t provide any insight into the absolute returns of an investment. A deal with a 25% IRR might sound great, but what if the total profit is minimal because the investment period is short? Conversely, a lower IRR project might generate significantly more cash in your pocket over the long term but look less appealing on paper.

Most importantly, that 25% IRR might be built on a stack of multiple risks and assumptions. Understanding the Types of Risk, and the Levels of Risk in each deal will tell you whether that 25% IRR is “worth it”. See my article “Risks and Rewards – What is a Risk-adjusted return?”

For a more accurate assessment, it’s often better to focus on metrics like Cash-on- Cash return, or  Equity Multiple, and it is always critical to dive deeper into the assumptions and risks driving the IRR figure.

At Sentinel Peak, we help our clients become smarter and more effective investors each day. Please reach out to us for a consultation.