Demystifying Investment Metrics Part 1: Internal Rate of Return vs. Average Annual Return

It is often said that a confused mind will say no.

When discussing investment deals, it can be overwhelming to understand the terminology and how to compare different deals.

Let me help you with that. In the next few articles I will go over key metrics to look at when comparing deals that will help you decide on what deal to invest in.

Today, we explore two crucial investment metrics:

1) Internal Rate of Return

2) Average Annual Return

Both play a significant role in assessing the profitability and potential risks associated with such investments. So, let's dive right in!

Internal Rate of Return (IRR): The Internal Rate of Return (IRR) is a metric widely used in the financial industry to evaluate the profitability of an investment over a given time period. It represents the annualized rate at which an investment's cash flows, including both income and expenses, generate a net present value of zero. In simpler terms, IRR measures the annualized return percentage an investor can expect to earn from their investment.

Example: Suppose you invest $50,000 in a multifamily syndication deal, and over the course of five years, you receive a series of cash flows, including rental income and potential profits from the sale of the property. At the end of the investment term, the net present value of all the cash flows amounts to $70,000. In this scenario, the IRR would be calculated as the rate that makes the present value of the $50,000 investment equal to $70,000. Let's assume it comes out to be 12%.

So, an IRR of 12% means that your investment in the multifamily syndication deal is expected to generate an average annual return of 12% over the investment term.

Average Annual Return (AAR): The Average Annual Return (AAR) is another important metric that investors use to assess the performance of an investment. It represents the average yearly return an investment generates over a specific period, often expressed as a percentage.

Example: Continuing with the previous example, let's say the investment term is five years, and the net present value of all cash flows is $70,000. The Average Annual Return would be calculated by dividing the net present value by the initial investment and expressing it as an annualized rate.

To calculate the Average Annual Return (AAR), we divide the net present value ($70,000) by the initial investment ($50,000) and then take the fifth root (since the investment term is five years). Finally, we subtract 1 to express the result as a percentage.

AAR = ($70,000 / $50,000)^(1/5) - 1

Assuming the calculation results in an AAR of 8%, it means that your investment in the multifamily syndication deal is expected to generate an average annual return of 8% over the five-year investment period.

Comparing IRR and AAR: While both IRR and AAR are valuable metrics, they provide slightly different perspectives on investment performance. IRR considers the time value of money, accounting for the timing and size of cash flows. On the other hand, AAR, on the other hand, provides a straightforward measure of the average annual return, but it may overlook variations in cash flows between different years.

In the next article, I'll help you understand cash on cash return and equity multiple.

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