McNellis: Lies, Damn Lies and the IRR

September 1, 2011

By John McNellis

Outright fraud in sales packages is about as rare as total amnesia. However negligently prepared offerings may be, they seldom contain jaw-dropping lies. If one says a property’s current gross income is $1 million, it usually is. And simple offerings—say a flyer pasted together by a residential broker selling a gas station—are seldom far off track. Why? Purported facts about the present are subject to verification, painful lawsuits spawn in the waters of outright deception, and the shallow-end players are careful.

So, too, are the sophisticates swimming in real estate’s deep end, but they can achieve depths smaller fish can only dream of. Through the magic of the internal rate of return, the big sharks can claim to be able to foretell the future. And while facts about the present are subject to door-pounding process servers, gilt-edged projections about the future are not.

An IRR calculation is simple in theory: One takes the projected annual cash flow an investor hopes to receive from a property for a given holding period—usually 10 years—and adds to that the property’s estimated sale value in the 10th year, and then uses the combined sum to calculate the total return on investment (or IRR) over that 10 year period. So, if a property pays 5 percent in annual cash flow over 10 years and then sells at the end of that 10th year for twice what the investor originally paid, the IRR would be not quite 11 percent. This plays a lot better in a prospectus than a measly 5 percent return.

It’s worth pointing out that if one assumes that rents and expenses remain constant during the 10-year period (this assumption will often prove wildly optimistic) and that the selling cap rate 10 years out will be the same as the buying cap rate today (more optimism), the IRR will be identical to the cap rate paid today; i.e. if you bought it at a 6 cap and received a 6 percent yield for the 10 years you owned it, then sold it for exactly what you paid for it, your IRR would be 6 percent, the same as your initial cap rate.

The breathtaking fallacy behind every IRR analysis ever prepared is obvious: It assumes one can predict highly complex and interrelated financial conditions—interest rates, capitalization rates, tenant demand, new competition, population growth, personal income shifts, etc.—10 years hence. A mere handful of people predicted the crash of 2008-9, and they did so only a year or two in advance. Two years ago, absolutely no one predicted that apartment prices would be soaring in 2011 or that A-quality commercial-building prices would equal their all-time highs.

Predicting how real estate will price in 10 years is, simply put, impossible. It’s akin to accurately predicting rainfall totals in 2021.

But, that they’d have as much luck picking the 2021 Super Bowl winner as in nailing long-range prices deters almost no one in real estate’s upper echelons. Glossy high-end sales brochures and investment committee reports routinely contain impressive-looking Argus spreadsheets that magically produce the IRR the buyer or investment committee desires. The magic is easier than voodoo—you just keep raising the anticipated 10th-year sales price until the desired IRR is hit. Who is going to be around in 10 years to tell the analyst he or she was wrong? Commissions and careers will be made and remade and bonuses paid many times over before the truth will out.

A buyer would have more fun—and get just as reliable information—consulting a fortune teller.

Alternate interpretations of the IRR acronym such as “inflated rate of return” or “I rationalize risk” should come to the mind of anyone confronted with reams of spreadsheets predicting rising rents, falling expenses, zero vacancy factors and impressively low cap rates.

That the old-school return on investment, or ROI, calculation is a much more precise measurement of financial performance means it’s of no value to large swaths of the real estate community. Its accuracy renders it too dismal a tool to be helpful to anyone selling the sizzle. A proper ROI calculation ignores cap rates and interest rates (by assuming a property is held free and clear, it deprives one of the funhouse-mirror distortions created by leverage) and looks only at what a property’s net operating income will be upon construction completion and full lease-up. If one has a fair bit of pre-leasing and a construction contract in hand when solving for ROI, this calculation can be quite accurate. For those selling the future as a far rosier place than today, this is devastating.

We all have our self-delusions. However, having them about numbers and the future values of our acquisitions is much more expensive than thinking we can actually carry a tune or that anyone really likes our whistling.

For more about John McNellis or McNellis Partners, please visit mcnellis.com.