Investment approach
Real Estate IRR in Plain English: When It Misleads
IRR turns a project's profit into an annual rate that reflects payment dates. Two projects with the same profit give 20% and 6.3% a year, and two cases show where the metric distorts the picture.
Real estate IRR (internal rate of return) is the annual rate at which all of a project's cash flows, discounted to today, add up to zero. Put simply: the average annual return on the money invested, with dates taken into account. IRR compares projects of different length well, but it misleads most often in two situations: on short projects with a small profit, and when part of the money comes back early.
What IRR shows, in plain English
A euro that comes back after one year is worth more than a euro that comes back after three. IRR measures that difference in a single number. The CFA Institute describes it as an estimate of a project's return under certain assumptions, which is compared with a hurdle rate (CFA Institute, Capital Investments and Capital Allocation). Invest €500,000 and get €600,000 back after a year, and IRR is 20%. If the same €600,000 arrives after three years, IRR drops to 6.3% a year: 1.2^(1/3) − 1. It is easy to check: 600,000 / 1.0627³ ≈ 500,000. The present value of the future €600,000 at a 6.27% rate equals the €500,000 invested, so the IRR is found.
| Project | Invested, € | Returned, € | Term | Profit, € | EM | IRR |
|---|---|---|---|---|---|---|
| A | 500,000 | 600,000 | 1 year | 100,000 | 1.20x | 20.0% |
| B | 500,000 | 600,000 | 3 years | 100,000 | 1.20x | 6.3% |
Worked example, not a forecast. The profit is identical, and the two projects cannot be told apart by equity multiple. IRR shows that B held the money three times as long. When you need to compare projects of different length, IRR is fairer than ROI.
When IRR misleads
Short term and a small profit
You invest €100,000 and get €110,000 back after three months. Annualised, IRR comes to 46.4%: 1.1^4 − 1. It looks impressive, yet the profit is €10,000. An annual rate assumes you will find an identical project and repeat the result four times in a row. For real estate with licences and renovation, that assumption rarely holds.
Early return of capital
Take two projects of €500,000 over three years. Both return €700,000, which is 1.4x.
| Project | Year 0 | Year 1 | Year 3 | EM | IRR |
|---|---|---|---|---|---|
| C | −500,000 | 0 | +700,000 | 1.40x | 11.9% |
| D | −500,000 | +250,000 | +450,000 | 1.40x | 16.4% |
Worked example. D did not earn more euros, it got part of its capital back sooner, and IRR pays a premium for that. The premium is real only if you put that €250,000 to work elsewhere at a comparable rate. If the money sits in an account at 2% for two years, D's three-year result comes to about 12.4% a year instead of 16.4%, and the gap with C narrows from 4.5 points to 0.5.
Professional literature supports this caveat. Ludovic Phalippou, writing on the CFA Institute Research and Policy Center blog on 8 November 2024, says IRR is not the same as ROI, and a rate of return for assets with interim cash flows cannot be obtained without assumptions about reinvestment. There is a mathematical caveat too. When cash flows change sign several times (investment, income, a further capital call, income again), the equation can have several roots, and Excel will show only one of them. IRR also knows nothing about project size: 20% on €50,000 and 20% on 5 M€ are the same thing to it.
How to use IRR without mistakes
- Look at IRR together with the profit in euros and the equity multiple. One number hides too much.
- Calculate from the actual payment dates (the XIRR function), not from rounded years.
- Ask where the returned money will go, and compare with the return on that alternative.
- Compare projects over one horizon, not the annual rates of projects with different terms.
- Check that the cash flows include purchase taxes, renovation, holding costs and selling costs. Without them IRR is higher than the project's real one. The general order of calculation is described in the article on how to calculate a project's return.
One last point. A project's IRR and an investor's IRR are calculated on different cash flows. The investor receives money after profit distribution, taxes and fees, so their IRR is usually lower. Why the figures diverge is covered in the article on project return and investor return.
Who gets little from IRR
An owner holding a property for ten years for rent: there is no exit with a price, and IRR rests on an assumed valuation at the end of the term. Someone comparing projects of very different size: they need euros, not only percentages. And anyone who sees an IRR without a cash flow table, because a number without its assumptions cannot be checked.
On the /methodology page, DNPI Capital defines project ROI and annual return by the formula (1 + ROI)^(12 / months) − 1; IRR and equity multiple are not described there. The investor calculator shows return on investment, profit and an indicative annual equivalent; the page has no XIRR calculation for cash flows with several dates, so that is done in a spreadsheet.
Questions and answers
What does an IRR of 15% mean in real estate?
The money invested grew by an average of 15% a year, with payment dates taken into account. The number does not say how many euros were earned, how risky the project is, or whether the result can be repeated.
IRR or ROI: which one should I look at?
Both. ROI shows the result for the whole project, IRR converts it into an annual rate. For projects of different length IRR compares better, while ROI shows the final profit more clearly.
Why does Excel show a different IRR than an online calculator?
Excel's IRR function treats periods as equal, while XIRR uses the exact dates. On projects with unequal tranches the difference is noticeable, which is why XIRR is used for real estate.
Can a high IRR be a bad sign?
It can. A very high IRR often means a short term, a small amount or an optimistic assumption about the sale price. Check exactly those places.
