The Commercial Classroom: Uses of IRR and NPV in Commercial Real Estate - by Smith

This column is offered to help educate agents new to commercial and investment brokerage and serve as a review of basics for existing practitioners. The Internal Rate of Return (IRR) may be used to measure the total performance of an investment property over time and to compare investment properties, even different types of properties. Which is the better deal - this office building or that retail center? In leasing IRR is used to compare tenant offers and to determine should one buy or lease a property (we will cover these topics in the next month’s articles). IRR and Net Present Value (NPV) are based upon performance projections of a building using time value of money concepts. In measuring the performance of an investment property, the IRR calculation takes into consideration the acquisition price, annual cash flows and the sale proceeds (also called disposition or reversion proceeds). The IRR evaluates all facets of the investment during the holding period (the entire time the investment is owned), and is stated as a percentage that reflects the annual performance of the property. Realistically the IRR is a true measure of the performance of a property because it considers both cash flows (annual performance) and the appreciation in value (purchase price vs. sale price) of the property over time (the holding period). An internal rate of return may be used to track the historical performance or project future income and values for a building. To do so a spreadsheet is developed projecting the annual income and expenses of the property over the length of anticipated ownership. Using the actual lease escalations, and typically cost of living rates for expense acceleration, each year’s potential Net Operating Income (NOI) (cash flow) is determined. The purchase price is known and the sale price is projected by applying a conservative cap-rate to the final year of the holding period. This provides the necessary figures to do the calculation. Calculating IRR is time sensitive and each year’s results must be included, even if there are negative cash flows or zero activity. The acquisition price is time period zero, and the final year in the holding period reflects both that year’s cash flow and the disposition proceeds. This is typically used for mid to large-size properties, but could be applied to any building. This also allows for the financial comparison of different size or types of properties: For example, comparing a shopping center to an office building investment. This may also be applied to properties that are or will be financed. Some customers, especially institutional investors, will set a specific Return on Investment (ROI) percentage as a requirement or goal for their purchases. They will project future value of a property based on existing leases or market trends. Using the desired ROI as the IRR they calculate NPV. How much they can pay for the property (acquisition price) to accomplish their ROI/ IRR goal. The same spreadsheet analysis will be used, the cash flows and ultimate future sales price are calculated but in this case we will be solving for the acceptable purchase price. Calculating IRR or NPV is not simple math, because it involves time value of money concepts which discount future values; specific programs or calculators must be used for these calculations. Edward Smith, Jr., CREI, ITI, CIC, GREEN, MICP, CNE, is a commercial real estate consultant, instructor and broker at Smith Commercial Real Estate, Cambridge, N.Y.