The Internal Rate of Return (IRR) is a fundamental measure of investment performance in commercial real estate. While IRR provides an overall picture of return, understanding the specific sources of this return—whether from operational cash flows or from the sale of the property—can provide deeper insights. Partitioning the IRR allows you to dissect the overall return and understand the contributions of each cash flow component. This article will demonstrate how to partition IRR using a straightforward example.
Step 1: Calculate the Overall IRR
The first step in partitioning the IRR is to calculate the IRR for all cash flows associated with the investment. This represents the overall IRR, considering both operational income and the eventual sale of the property.
Suppose we have an office building investment with the following expected cash flows:
There is a 100,000 upfront investment. Each year the building produces cash flow of 10,000, and then at the end of year 5 the property is sold and produces net sale proceeds of 100,000.
When we calculate an IRR on this set of cash flows, we get 10%.
Step 2: Calculate the Present Value of Each Operational Cash Flow
Next, calculate the present value (PV) of each operational cash flow using the IRR calculated in Step 1 as the discount rate. The operational cash flows are the amounts received each year from renting out the office building. Each of these cash flows is discounted back to the present value using the IRR:
The key is to use the IRR calculated in step 1 as the discount rate for these present value calculations. We use the IRR from step 1 as the discount rate because we are trying to figure out how much of the total return comes from the operational cash flows versus the eventual sale of the property. By discounting the operational cash flows using the overall IRR, we can isolate and understand the contribution of these periodic cash flows to the investment’s total return.
The formula for calculating the present value for each cash flow is:
Step 3: Calculate the Present Value of the Sale Cash Flow
Now, calculate the present value of the cash flow from the sale of the property. The sale proceeds are also discounted back to the present using the IRR.
The formula to calculate the present value of the net sale proceeds is:
Step 4: Sum the Present Values of Operational and Sale Cash Flows
In this step, sum the present values of the operational cash flows and the present value of the sale proceeds. The total present value should equal the initial investment amount, confirming that the IRR calculation is correct.
Since the total present value of the combined cash flows is 100,000, we know the IRR is correct. This is because the internal rate of return is defined as the interest rate that causes the net present value to equal zero. In other words, the present value of all future cash flows is 100,000, and the initial investment is -100,000. When we add these two together, we get a net present value of 0.
Step 5: Calculate the Percentage Contribution of Each Partition
Finally, calculate the percentage contribution of each component (operations and sale) to the total present value. This is done by dividing the present value of each component by the total present value and then multiplying by 100 to get the percentage. These percentages represent the contribution of operational cash flows and the sale proceeds to the overall IRR.
The partitioned IRR can be summed up in the following table:
IRR Partitioning
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Conclusion
Partitioning the IRR allows you to gain a deeper understanding of where your return is coming from—whether from ongoing operations or the final sale of the asset. This knowledge can help you make more informed decisions, better manage risks, and tailor your investment strategies to your risk tolerance and return expectations. By following the steps outlined in this article, you can successfully partition the IRR for your own real estate investments.