Investors must know how to measure the returns on an investment in order to determine whether the investment is a success or failure. They also need to be able to gauge the performance of any investment managers they invest alongside, including mutual funds, real estate investment trusts, and private equity firms like us. In every asset class, managers or sponsors are judged against a benchmark, whether a formal index or simply an individual investor’s self-determined hurdle rate.
There are many ways to analyze the profitability and investment returns of a project or property. In commercial real estate, two of the most common metrics that investors use to measure performance are Compound Annual Growth Rate (“CAGR”) and Internal Rate of Return (“IRR”). We will examine each of these in depth, explain how to calculate them, and discuss when to use them.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. We go to great lengths to analyze the potential CAGR and IRR for every investment that we perform due diligence on. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
What is CAGR?
Let’s start by explaining compound annual growth rate, or CAGR as it is often known in financial circles. The performance of a commercial real estate investment, or any set of investment options, tends to fluctuate over time based on various factors, including market conditions, interest rates, and macroeconomic factors. In order to judge the performance of their investment, investors need a way to account for these annual performance fluctuations over a multiyear period.
CAGR is the solution to this. It allows investors to see the average return on investment over the holding period or period under analysis. CAGR is the average annual return of an investment over a specified period of time.
This is an important tool for any investor to understand because it is the primary way that investors and financial analysts break down a total return for a holding period into an annual rate. Essentially, it allows an investor to see their average returns over a period of time.
Breaking Down the CAGR Formula
The math behind CAGR isn’t that difficult to understand if you take a moment to learn about the different components and how to use them in the CAGR formula.
The CAGR formula is as follows:
CAGR = [(Final Value) / (Beginning Value)] ^ (1/t) – 1
Let’s define the terms of the formula in the context of a commercial real estate investment:
Beginning Value: value of the property at the beginning of the investment period
Final Value: value of the property at the end of the investment period. This is also sometimes known as the Ending Value.
t: number of years the asset is held for
An example can help to clarify. Let’s suppose that an investor purchases a commercial property for $1,000,000 in the first year and owns it for ten years. The investor experiences the volatility of the market over this period and actually sees the value of their property decrease in the first two years but subsequently watches the value of the investment increase over the rest of the ten-year holding period. The market value of the property looks like this at the end of each year:
Year 1: $1,000,000
Year 2: $900,000
Year 3: $950,000
In order to calculate the CAGR over this time period, the investor would solve the CAGR equation. The first step in doing this is to list the terms of the equation:
Beginning Value: $1,000,000
Final Value: $2,000,000
t: 10 years
Remember, CAGR = [(Final Value) / (Beginning Value)] ^ (1/t) – 1
So in this example, CAGR is calculated as follows.
CAGR = [ (2,000,000) / (1,000,000) ] ^ (1/10) – 1 = 7.18%
Based on the terms of this equation, the compound annual growth rate in this scenario is 7.18%. This means that despite the market volatility, the investment returned 7.18% annually. It is important to note that the CAGR as calculated will probably not be experienced by the investor in any given year. In our example, the investor did not experience a return of 7.18% in any given year, but over the entire holding period the return averaged out to 7.18%.
What is IRR?
Like CAGR, internal rate of return, or IRR, is a metric used by commercial real estate investors to calculate the profitability of an investment. Unlike CAGR, the IRR calculation relies on cash inflows and cash outflows over the holding period to provide the investor with a gauge of profitability. If an investor uses IRR to calculate the estimated profitability of a commercial real estate investment or to assist in making investment decisions, they will need to estimate the future cash flows generated by the property. Estimates of cash flows over the holding period are typically found in the proforma financial statements for the investment property.
Investors should think of IRR as the interest rate earned on each dollar invested over the holding period. In technical terms, the IRR is the discount rate that results from using the estimated cashflows to calculate a net present value (NPV) equal to zero. For more information on net present value calculations, see our article on this topic. The important thing to know is that a higher IRR indicates a more profitable investment.
How Do You Calculate IRR?
On paper, the calculation for IRR is complex, but anyone can calculate IRR using a financial calculator or a spreadsheet tool like Microsoft Excel. Regardless of which tool is used, investors need to estimate the cash flows that the property will generate over the holding period. As mentioned, this typically requires a commercial real estate proforma to forecast the cash flows to be received by the investor. These cash flows are the inputs for the IRR calculation.
An example can help to show how IRR is calculated. Let’s assume an investor purchases a commercial property today for $1.5M and sells it five years later for $2M. In years one through five, the investor receives the following cash flows on an annual basis.
Year 0: -$1,500,000 (this is the initial investment amount allocated to purchase the property)
Year 1: $400,000
Year 2: $450,000
Year 3: $420,000
Year 4: $430,000
Year 5: $2,500,000 (this is the last cash flow of $500,000 and the lump sum received upon the sale of the property for $2M)
The easiest way for an investor to calculate IRR is to use a spreadsheet tool to calculate the IRR based on the cash flows estimated in the proforma. These tools tend to have IRR functions built into them. For example in Excel, the formula is =IRR(), and the investor can enter the cash flows above into this formula to calculate that the IRR in our example is 32.2%.
CAGR vs. IRR in Commercial Real Estate Investing
There are advantages and disadvantages to using CAGR and IRR when evaluating or measuring the performance of commercial real estate investments.
How to Use CAGR to Measure CRE Investment Returns
Individual accredited investors may decide that investing in a private equity firm is the best way for them to gain exposure to the commercial real estate asset class. These investors will probably look at several potential private equity sponsors before deciding on one to invest in. The research that the individual does at this stage is known as due diligence, and understanding the past performance of the firm is an important part of the process.
One of the best ways for investors to learn about the past performance of a private equity sponsor is to look at the historical CAGR generated by the management team. While it is not necessarily predictive of future results, it will help the investor to understand whether the firm has been successful in the past. It will also allow investors to compare the past performance against alternative firms and asset classes over the same period. This will help the investor to feel confident that they are choosing to allocate their capital in a way that meets their financial objectives and fits their risk profile.
How to Use IRR to Evaluate CRE Investments
It is important for commercial real estate investors to understand that IRR can be used to build discipline into the investment process. For example, an investor might draft a business plan that states that investment properties are only to be purchased if the expected IRR exceeds 15%. As the investor performs due diligence on potential investments, they will find that some do not meet or exceed this hurdle rate. These properties should not be purchased if the investor intends to stick to their plan.
Calculating an IRR for each potential investment also allows investors to rank different investments against one another. In other words, if an investor is faced with three potential investments, they can create pro forma financial statements for each one. The investor can then calculate the IRR for each investment. Generally speaking, the one with the highest IRR is the one that should be pursued. If for some reason, it is unavailable, then the investment option with the second highest IRR should be purchased, assuming it meets the investor’s minimum IRR threshold.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in. If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com.