Project IRR and Equity IRR Simplified

Executives, analysts, and investors often rely on internal-rate-of-return (IRR) calculations as one measure of a project’s yield. Real Estate Firms commonly use it as a shorthand benchmark to compare the relative attractiveness of diverse investments. The purpose of calculating the IRR is to determine if the rate of return of a project is greater than its cost of capital. Investments with the highest IRRs are considered the most attractive and are given higher priority.

Hypothetically speaking, IRR is defined as the discount rate which, when applied to discount a series of cash flows, results in a net present value equivalent to zero. An intuitive way of understanding IRR is to think of it as equivalent constant interest rate at which a given series of cash outflows must be invested in order for the investor to earn a given series of cash inflows as income. It is in this sense a measure of the underlying return the investor expects to achieve by investing in capital.

There are two useful classifications of IRR when making real-estate investment decisions; Project IRR and Equity IRR. A project’s IRR can be attained taking in consideration only the project’s cash flows (excluding the financing cash flows). Initially, IRR is determined at the project level, without considering cash flows related to financing i.e. when computing for the project IRR, amortisation and interest payments are excluded.

To illustrate, let's consider a project with an initial construction cost of $1,500,000, and annual rental income of $125,000. Assume after 10 years the property will be sold for $6,250,000. You can construct the project cash flows and calculate the project IRR by using the Excel IRR formula. From the calculation, we find the project has a 20% IRR and an NPV of  $2,068,258.77 at a discount rate of 8% as shown below.

                             

On the other hand, calculating Equity IRR is a different process. Equity IRR assumes the use debt to finance the investment, hence, any debt raised for the project is deducted from net cash inflows. However, if the project is fully funded by equity, the Project IRR and Equity IRR will be the same. If the project is fully funded by debt, Equity IRR simply does not exist. 

Let's assume that in our earlier example, 66.6% of the project is funded by debt while the remaining 33.3% is funded by equity. The cost of debt is 4%. The cash flows for equity holders and the equity IRR can be calculated using the same excel formula as above. We find that our Equity IRR is 29%. 

We can calculate the Interest + principlal payment using the following formula:

L[c(1+c)^n]/(1+C)^n-1]  

Where; 
L is the loan value  
C is Interest rate, and 
n is the number of payments.

Otherwise, we can use the PMT option in excel to calculate the principal payment. This option will ask you for arguments for the interest rate, number of payments, and the PV of the loan (the amount of the loan the day you withdrew it). 

A reoccurring question is whether the Equity IRR is always higher than the project IRR- the answer is no. The project IRR will be higher than the Equity IRR only when the cost of debt exceeds the Project's IRR. In our example, the project IRR will only exceed the Equity IRR if the cost of debt exceeds 20% (our project's IRR). 

In terms of the investment decision, a positive Equity IRR indicates that based on the set of assumptions used, the project under evaluation generates more than the required rate of return by investors, hence, the project should be accepted. Contrarily, a negative Equity IRR indicates that the project is unable to generate the required rate of return by investors, and hence, should be rejected. An Equity IRR of zero means that the project's rate of return is just equal to the cost of capital. The project would neither make you richer or poorer; it is worth what it costs. Thus the IRR rule states that the project should be accepted. Accordingly, our project under evaluation with Equity IRR of 29% should be accepted.