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Internal rate of return

The internal rate of return is the discount rate that makes the present value of an investment's expected cash flows equal to the amount invested. The number expresses the annual return the investor receives across the whole holding period under the assumptions of the model, and it is one of the two most used measures of a property investment alongside net initial yield.

In practice, the internal rate of return is calculated from the cash flow in a discounted cash flow model. The model contains the purchase price in year 0, periodic net operating income in each year, and an exit value in the final year. The internal rate of return is the rate that sets the present value of this flow to zero (a number that is typically solved iteratively in a spreadsheet or an analysis tool). If an investor buys a building for NOK 500 million, receives NOK 25 million a year for 7 years and sells for NOK 600 million, the internal rate of return is around 8.5% before gearing.

Two variants matter: ungeared internal rate of return (on the property's own cash flow) and geared internal rate of return (after borrowing costs and principal repayments have been deducted). The geared internal rate of return is typically 200-500 basis points higher than the ungeared one when the loan-to-value ratio is 50-70%, but it is also more sensitive to interest rate changes and must always be read together with the debt service coverage ratio. Norwegian property funds typically report the geared internal rate of return (equity IRR) in prospectuses; institutional investors more often look at the ungeared figure to compare across capital structures.

The internal rate of return has known weaknesses as a modelling tool. It assumes that cash flows are reinvested at the same rate, which is rarely realistic. Models with uneven cash flow (negative during the development phase, positive later) can produce several possible internal rates of return or confusing results. Professional investors therefore use the internal rate of return together with present value, multiple on invested capital (MOIC) and a geared/ungeared split, not as the only measure. The observed internal rate of return must also be set against what a building category and location actually deliver in the market: a 12% geared IRR on a prime office in Vika is probably too optimistic; 8% on a development portfolio with developer risk is probably too low.

In Placepoint you can compare tenants, lease length and building standard from the property panel when you set the assumptions behind an internal rate of return calculation.

How it looks in Placepoint

In Placepoint you find this in Property panel - Units and Tenants:

Internal rate of return in Placepoint

From Placepoint's glossary: Internal rate of return

More information: Eiendom Norge: Market Reports, Store norske leksikon: internrente, Akershus Eiendom: Market Report

English: Internal rate of return (IRR).

Common questions we come across

What is the difference between ungeared and geared internal rate of return?

The ungeared internal rate of return is calculated on the property's total cash flow (without debt). The geared internal rate of return is calculated on the equity after borrowing costs and principal repayments have been deducted. The geared figure is typically higher at a positive loan-to-value ratio, but it is also more sensitive to the interest rate level.

What is a good internal rate of return for Norwegian commercial property?

An ungeared internal rate of return of 6-8% is typical for stabilised commercial property; 9-12% for development or higher-risk buildings. Geared figures sit 200-500 basis points higher at 50-70% gearing. The numbers vary with the macro picture and must be set against the risk-free rate and the market cycle.

What is the difference between the internal rate of return and the capitalisation rate?

The capitalisation rate is the discount rate used in a direct model where the present value is set equal to one period of net rent divided by the rate. The internal rate of return is a calculated return from a multi-year discounted cash flow that includes both ongoing rental income and an exit value.

When is the internal rate of return a poor measure?

When the cash flow changes sign (development with negative cash flow early and positive later can give several internal rates of return), or when the reinvestment assumption is unrealistic. In those cases, use the modified internal rate of return (MIRR) instead, or supplement with present value figures.