IRR v AAR, A Pragmatic Review

"The stability in national AIMI values underscores the essential strength of the multifamily market for potential investors. Property price and net operating income growth continue to outperform their historical averages in the majority of metros. What's more, despite relatively high multifamily construction, the overall strength in the labor market and underlying demographic trends are creating robust demand for new multifamily units."

-Steve Guggenmos, Vice President at Freddie Mac Multifamily Research and Modeling

Hi Nuvo Community,

This week our focus is understanding deal presentation, and the mechanics behind the numbers.

Before we jump in, let’s break down the fundamental difference between Internal Rate of Return (IRR) and the Average Annual Return (AAR). The metric of AAR is growing in popularity, but why?

Simply put, IRR takes into account the overall performance of the investment, weighing the initial capital, the time it takes to recoup the investment, and the total return holding constant the time value of money. The longer it takes to realize a positive return, the lower the IRR.

In stark contrast, AAR takes a straight-line average of the AVERAGE cash on cash throughout the deal life. AAR’s can be projected and adjusted with a quick adjustment to the exit cap rate.

In the following graphs, we illustrate what happens to the IRR vs the AAR in four different operating scenarios.

Scenario One

The property is purchased with fixed agency debt, 65% leverage, 3% NOI growth annually. The average cash on cash during the hold period is 6.5%-7%. Now averaging the net proceeds against the initial equity, the AAR is 31.64%, pretty solid right? The IRR is 10.62%, probably not an accretive risk adjusted return for most institutional groups.

Scenario Two

The same property is purchased, but the property faced operational headwinds. Fortunately, the operator was able to maintain NOI, but the floating rate bridge debt really ate into the net cash flows. The sponsor in this instance put in additional capital in year four of the investment to cover the negative cash flow.

Scenario Three

In this scenario, something we are calling “worst case” is negative NOI growth, increasing debt service, and capital calls. As you can see, the property still returns a positive average annual return, but a negative IRR.

One Key Takeaway, is if the AAR is below hold period in years divided by 1, a full return of capital is not achieved. For instance, in this example the investment period is 5 years, which would mean the minimum AAR for the investment to break even is 20%. In this example, a breakeven exit cap rate to solve for a 20% AAR is 5.75%.

Key Takeaways & Questions to Ask

If you are presented a potential investment with AAR and the leading metric, be sure to follow up with, what is the IRR? What sort of exit cap rate assumptions are being made? How has the asset performed to date?

All the best,

Yuri - Your Real Estate Investigator

Credit: Stuart Keller, Chief Investment Officer, Nuvo Capital Partners

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