The internal rate of return (IRR): projections, benchmarks and pitfalls
| Date | 05 September 2016 |
| Pages | 664-669 |
| Published date | 05 September 2016 |
| DOI | https://doi.org/10.1108/JPIF-07-2016-0059 |
| Author | Michael Patrick,Nick French |
| Subject Matter | Property management & built environment,Real estate & property,Property valuation & finance |
EDUCATION BRIEFING
The internal rate of return
(IRR): projections, benchmarks
and pitfalls
Michael Patrick and Nick French
Department of Real Estate and Construction,
Oxford Brookes University, Oxford, UK
Abstract
Purpose –The purpose of this paper is to discuss the use of the internal rate of return (IRR) as a
principal measure of performance of investments and to highlight some of the weaknesses of the IRR in
evaluating investments in this way.
Design/methodology/approach –This Education Briefing is an overview of the limitations of the
IRR in making capitalbudgeting decisions. It is illustrated with a number of counter-intuitive examples.
Findings –The advantage of the IRR is that it is, on the surface, a wonderfully simple benchmark.
One figure that tells a story. But, the disadvantage is that if used in isolation the IRR can give
misleading results when used to assess investment proposals.
Practical implications –The IRR should be used in conjunction with other analyses to appraise
projects, so that the user can determine its veracity in the context of other benchmarks. This context is
particularly important when assessing investments with unusual cash flows.
Originality/value –This is a review of existing models.
Keywords Performance measurement, Property valuation, IRR, Expected rate of return,
Internal rate of return, Target rate
Paper type General review
Introduction
In a previous Education Briefing (French and Patrick, 2015), we looked at the plethora
of yields and benchmarks that are used in the finance world. This concluded that
yields, in all their forms, are simply expressions (normally in percentage terms) of the
attractiveness of an investment. They are benchmarks; nothing more, nothing less and
different investors use different benchmarks.
That said, the internal rate of return (IRR) is probably the preferred performance
measure for the real-estate industry as a means of assessing projected investment
returns. However, finance textbooks, including those specifically on real estate such as
Brown and Matysiak (2000) indicate that net present value (NPV) is a superior method
to IRR for evaluating potential investments.
But, in practice, theIRR remains dominant. It is a simple metric to understand and its
appeal is that it meets the demand for a single number against which a project can be
compared with otheropportunities or a benchmark. Thissimplicity belies its true nature
and the many problems that can arise in using it to assess capital investment projects.
This paper reviews what the IRR is, illustrated with examples of cash flows where it
gives a misleading or erroneous result.
Journal of Property Investment &
Finance
Vol. 34 No. 6, 2016
pp. 664-669
©Emerald Group Publishing Limited
1463-578X
DOI 10.1108/JPIF-07-2016-0059
Received 25 July 2016
Accepted 25 July 2016
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1463-578X.htm
The authors would like to thank the inquisition of the MSc Real-Estate Student, Robin Tuck, for
the inspiration for this paper.
664
JPIF
34,6
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