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Introduction
In a previous Education Briefing (French and Patrick, 2015), we looked at the plethora of yields and benchmarks that are used in the finance world. This concluded that yields, in all their forms, are simply expressions (normally in percentage terms) of the attractiveness of an investment. They are benchmarks; nothing more, nothing less and different investors use different benchmarks.
That said, the internal rate of return (IRR) is probably the preferred performance measure for the real-estate industry as a means of assessing projected investment returns. However, finance textbooks, including those specifically on real estate such as Brown and Matysiak (2000) indicate that net present value (NPV) is a superior method to IRR for evaluating potential investments.
But, in practice, the IRR remains dominant. It is a simple metric to understand and its appeal is that it meets the demand for a single number against which a project can be compared with other opportunities or a benchmark. This simplicity belies its true nature and the many problems that can arise in using it to assess capital investment projects.
This paper reviews what the IRR is, illustrated with examples of cash flows where it gives a misleading or erroneous result.
Performance measurement and the IRR
Any investment will only become a good investment if it achieves, or exceeds, the expected returns that were factored into the pricing of the investment at the time of purchase.
In determining whether an investment will prove to be a good investment in the future, it is normal that the investor pays heed to how that investment has performed previously. And, whilst past performance is no guarantee of future performance, it is an important influence on the measurement of the financial attractiveness of an investment. Measures of performance are yields/returns that the investor has actually received over the preceding time period.
If the cash flow turns out to be exactly as predicted, then assuming the asset was rationally priced, the investor will have achieved exactly the target rate of return (required rate of return) they had hoped. If the cash flow is higher than expected, the actual return will have been greater than the target rate; if the cash flows are less than expected, the actual return will be less than...