What is IRR in Real Estate Investing?
Many real estate investors rely on the Internal Rate of Return (IRR) as a key measure of a project’s return performance. IRR is favored due to its consideration of the time value of money. This concept recognizes that a dollar received today holds more value than a dollar received in the future within the context of real estate investments, primarily because of inflation and other factors.Â
The swiftness of returns significantly influences IRR. In essence, the quicker and more frequent the cash distributions to investors, the higher the IRR. In this article, we aim to demystify the Average Annual Return (AAR) within real estate investing by explaining its significance, providing an example, and contrasting it with IRR.
What is AAR in Real Estate Investing?
The Average Annual Return, or AAR, is a formula used to evaluate an asset’s performance over time. To calculate it, you sum up all the cash flow and profit generated during the investment’s duration, and then divide this sum by the initial investment, dividing the result by the number of years the investment is held. The AAR signifies the annual average profit of the investment, making it a valuable tool for comparing investments with varying time horizons.Â
To illustrate, if a $100,000 investment is expected to yield $100,000 in returns over five years, the AAR would be 20 percent.
An Example of AARÂ
AAR measures the Average Annual Return generated and averaged over each year of an investment’s holding period. A respectable AAR for a deal typically falls between 19-24%, though this can vary based on the market and investment class.
For example, if you invested $150,000, and after operating expenses, you generated $120,000 in cash flow and return from the sale over four years, your AAR would be 20%.
The Importance of AAR in Real Estate Analysis
AAR is an essential metric for evaluating an investment’s historical performance. It applies not only to real estate but also to other investment types like stocks and bonds. Investors typically consider average yearly returns over three, five, and ten years to assess an investment’s performance. When evaluating a commercial property, it’s crucial to compare the current annual return to historical returns, alongside other metrics like IRR, cash on cash return, and return on equity.
AAR vs. IRR
In private real estate investments such as multifamily syndications, AAR and IRR are commonly used return metrics. They both gauge projected returns, but they differ in how they calculate them. IRR (Internal Rate of Return) estimates the anticipated annual growth rate, accounting for the value of these returns over time, considering the time value of money due to inflation. In contrast, AAR does not consider the time value of money. While AAR and IRR may seem similar as they often present double-digit percentage returns, IRR offers a more comprehensive view of future profits and their value in the market.
Conclusion
While AAR is a useful metric for analyzing real estate investments, it’s essential to consider other metrics as well. Evaluating investments with multiple metrics will provide you with a comprehensive perspective to select deals that align with your risk profile and return expectations. Focusing on IRR is recommended, as it offers a more comprehensive view of future profits and their value in the market.
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If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (949) 785-0877 or invest@cramletcapital.com