IRR Explained: A Smarter Way to Measure Returns
Weighing up different investment opportunities like commercial property, term deposits or shares is often tricky because you’re comparing very different things with different risks, returns and timeframes.
It’s easy to just look at the headline rate – such as the average annual cash return or fixed interest amount – and make your decision from there.
But that approach ignores key factors such as timing, cash-flow patterns, capital appreciation and tax – all of which can significantly impact your investment decision.
That’s why at Classic Collectives Ltd, we consider the Internal Rate of Return (IRR) before buying any commercial property. IRR is a widely used measure of investment performance that can help you compare different investment opportunities on a level playing field. It reveals how good a potential investment is by factoring in not just how much money you’ll make, but also when you’ll make it.
What is IRR and why is it important?
In simple terms, an IRR tells you the average yearly return you can expect, adjusted for the timing of when money comes in and goes out. Holding property for the long term typically involves a large investment to buy the building (money going out), rental income over many years (money coming in), and then significant proceeds should a sale eventuate (including any gain on sale). But the annual cash return might look quite similar to a low-risk term deposit.
However, if you dig deeper and calculate the IRR, it tells a different story. Over the past decade, when considering current valuations or after a sale, Classic Collectives Ltd has averaged 9%-11% IRR for our commercial property investments. This figure includes both rental income and capital growth (but excludes the benefit of depreciation which provides some tax shielding. If you compare this to term deposit rates, which can vary from 3%-6%, then the long-term value of commercial property becomes clearer.
Admittedly, higher returns can reflect higher risks and lower liquidity – but at least this can be factored into your decision making.
One example we manage is a commercial property purchased locally six years ago. During this time, interest rates have risen and the building’s market value has fluctuated. But as the table below shows, the IRR is currently a very healthy 13.67% (after tax) which demonstrates how commercial property can perform over time, notwithstanding the ups and downs of the market.
In a nutshell, IRR reflects an investment’s annualised return over time, not just how much it earns in any single year.
Making informed decisions
Classic Collectives Ltd considers quarterly rental income, the initial purchase price and estimated future sales price, when calculating an IRR for each property we’re looking to buy. This IRR metric is included in our investment prospectus, and it’s a figure we continue to monitor over time.
Examining the IRR (whilst keeping in mind liquidity and risk) allows our investors to compare multiple investment opportunities with different cash flow patterns and holding periods, so you can choose the most efficient use of your capital.
We hope it provides another valuable piece of information for you to consider when weighing up your investment options.
As always, if you have any questions or would like to know more, feel free to get in touch.
- Email: Daniel.watkins@classic-group.co.nz
- Phone: 027 577 1755
