Everyone uses this metric...I refuse to

Laziest Landlord -

Internal Rate of Return (IRR) is a common metric in real estate. Google "Real Estate" and "IRR". You'll see.

What is IRR? And why do I reject it? Let's start with the first. And then I'll explain why I would need psychic powers to not reject it.

IRR is an all-in-one measure of future cash flows. It's loved in real estate because it is one number. (Easy to understand). It looks at cash flow. (Good). It's the interest earned on a dollar invested up front. It's best illustrated with an example.

Say I buy a property for $300,000 with 20% down. I do a quick P&L and figure out I'll generate $5,000 in cash flow for 10 years. I estimate this will increase 3% each year. And then I'll sell the property and gain $50,000 equity.

My IRR, Excel says, is 8.2%.

Here's why I reject IRR. I've had to make many assumptions. Big ones. Without being a psychic, I've had to assume:

  1. I will sell in 10 years' time.
  2. The value of the property a decade from now.
  3. Tax rates and depreciation write off to figure out annual cash flow.
  4. One off expenses and when they may (or may not) happen.
  5. Cash flow will continue increasing at a fixed percentage.

IRR is particularly sensitive to #1 and #2 above.

Let's take a very real possibility. The cash flow isn't $5,000 per year growing at 3% but $4,750 at 2%. And say I have to sell 7 years from now and not 10 and get $35,000 in equity rather than $50,000.

Suddenly my IRR no longer looks like a healthy 8.2%. It's now just 2.9%! And all I did was to tweak my assumptions slightly:

I get asked regularly "what's the IRR?" by people trying to sound smart. I reply "I don't care". Why? For the exact reason above. It's too sensitive to highly likely scenarios.

I look at five other metrics for the first five years. Why? Because they rely less (not zero) on assumptions. And they tell me useful things within a margin of error.  

Here is another reason why I reject IRR. Say the same property is run down and requires $16,500 investment in a new roof. With a new roof I think I can get $7,000 a year in cash flow, again increasing by 3%.

Both have the same IRR. Which is better? I now have to put more cash in (do I have enough?) and hope I get more cash flow. But will my selling price be higher with a new roof 10 years from now?

Being the Laziest Landlord is about financial security. Security means a high degree of certainty. And IRR just doesn't have that certainty. It requires too many assumptions or great psychic powers.