Internal Rate of Return (IRR)

Why IRR exists

Two deals each hand back $1,450,000 on a $1,000,000 investment. One takes three years, the other takes six. The profit is identical. The return is not remotely the same. IRR is the tool that tells them apart.

Technically, IRR is the discount rate that makes every cash flow in a deal — the money going out and all the money coming back — net to exactly zero in today's dollars. In plain terms, it is the compounding rate your money earned while it was tied up, counting precisely when each dollar arrived.

That timing sensitivity is the entire point. A distribution received in year one can be put to work for the rest of the hold; the same dollar received at sale cannot. IRR rewards cash that comes back early and punishes cash that comes back late, which is why it cannot be worked out by hand and needs a solver like an IRR calculator.

A three-year hold, laid out

An investor puts $1,000,000 of equity into a small multi-tenant office building, holds it three years, then sells.

• Day one — −$1,000,000 of equity goes in
• End of year 1 — +$62,000 of cash flow after debt service
• End of year 2 — +$70,000, as a below-market lease rolls to market
• End of year 3 — +$78,000 of cash flow plus $1,240,000 of net sale proceeds after loan payoff and closing costs, for +$1,318,000

Total returned: $1,450,000. Total profit: $450,000. Those four figures solve to an IRR of roughly 13.9%, and to an equity multiple of 1.45x.

Look at where the return comes from. Three years of operating cash flow add up to $210,000. The sale contributes $1,240,000. In most commercial deals the exit dominates the IRR — and the exit is the part of the model nobody can verify in advance.

What it means for you

If you are raising money, IRR is the number your investors will quote back to you, and it is largely a function of two things you must defend: how long you hold and what you sell for. If you are the one being pitched, IRR is where optimism hides most comfortably.

There is a financing angle too. Because IRR is driven by timing, anything that returns capital sooner lifts it — an early refinance that pulls equity out, an interest-only period that boosts distributions, a partial sale. That is a real strategy, not a trick, but it changes the risk profile. If part of your plan involves recycling equity before the sale, look at how a CRE bridge loan and its takeout would actually sequence, then run the terms through a commercial real estate loan application before you promise a number to anyone.

Where IRR gets manipulated

• The hold period does the heavy lifting. If that same $1,450,000 came back as one payment, three years is about 13.2% annualized and six years is about 6.4%. Identical dollars, half the return. Any IRR quoted without a stated hold period is meaningless.
• The exit cap rate is an assumption, not a fact. Models that sell at a cap rate lower than the purchase cap rate are assuming the market improves. Ask what the IRR looks like if the exit cap is 50 to 100 basis points higher than going in. If the deal only works on cap rate compression, it is a bet on the market, not on the building.
• IRR says nothing about size. A 40% IRR on $50,000 held eight months returns less money than a 12% IRR on $2,000,000 held five years. Always read IRR next to the equity multiple.
• It assumes you reinvest at the same rate. The math implicitly assumes every distribution gets redeployed at the IRR itself. In practice it sits in a bank account. The higher the quoted IRR, the more unrealistic that assumption becomes.
• Unusual cash flow patterns can break it. If a deal has a capital call after distributions have started, the sign of the cash flow flips twice and more than one mathematically valid IRR can exist. Development and heavy value-add projects are the usual culprits.

What is a good IRR for a real estate deal?

It depends on risk. Stabilized, long-hold properties with fixed debt are often underwritten in the low double digits; value-add business plans commonly target the mid-to-high teens; ground-up development is usually pitched higher still because more can go wrong. A high IRR is not a sign of a good deal on its own — it is a description of how much risk the sponsor is taking with your money.

What is the difference between levered and unlevered IRR?

Unlevered IRR runs the property's cash flows with no loan at all, which isolates how the real estate itself performs. Levered IRR subtracts debt service and the loan payoff, showing what the equity earns. Levered IRR is usually higher, but it is also far more sensitive to rate changes, refinancing risk, and the terms of the loan.

Can IRR be misleading?

Yes, more easily than almost any other metric in real estate. Shortening the assumed hold, assuming a lower exit cap rate, or front-loading distributions all raise IRR without changing the underlying property. The standard defense is to read IRR alongside the equity multiple, the assumed hold period, and the exit cap rate — three numbers together, never the one on its own.