Targeted internal rate of return, or IRR, is used widely to advertise deals on Crowdfunding sites, real estate and otherwise. While target IRR means something to sophisticated sponsors and investors, its widespread and uncritical use makes me a little uneasy, for the following reasons:
- If pressed, many people don’t know what IRR really means. Investors assume that a higher IRR is better than a lower IRR, but many couldn’t explain exactly why or how.
- IRR can be misleading. For example, a bond purchased for $100 that pays interest of $10 at the end of each of the first four years and $110 at the end of the fifth year has an IRR of 10%. A bond purchased for $68.30 that pays nothing for four years and $110 at the end of the fifth year also has an IRR of 10%. But those two investments are very different. The IRR calculation assumes that the $10 interest payments on the first bond can be reinvested at 10%, which is probably not true.
- The IRR of a real estate deal (or any deal) increases when the asset is refinanced and the proceeds distributed to investors. But refinancing the asset doesn’t necessarily make for a better investment.
- There being no such thing as a free lunch in capitalism, a higher IRR generally coincides with higher risk. For example, I can usually increase my IRR by borrowing more money. That relationship is not typically highlighted.
- For a typical startup outside the real estate industry, IRR has no meaning. Or to put it differently, a 28% target IRR for a startup plus $2.75 gets you on the New York subway.
- The term “target IRR” tends to mask what’s really important: the factual assumptions concerning sales and asset appreciation. To say “We expect a target IRR of 18%” is somehow easier to sell than “We expect the property to appreciate at 6% per year.”
- Under FINRA Rule 2210, offerings conducted through a broker-dealer may not advertise target IRRs. FINRA also prohibits Title III Funding Portals from advertising target IRRs, and the SEC prohibits new issuers from advertising a target IRR in Regulation A offerings, even for sponsors with extensive track records. Hence, target IRR cannot be used to compare offerings across all platforms and all deal types.
What can we do better as an industry? Here are a few ideas:
- We can explain internal rate of return better, maybe with examples and a standardized presentation and graphics.
- We can develop other apples-to-apples metrics for comparing deals.
- We can make clear that higher IRRs generally come with higher risks.
- In Regulation A offerings, and even in Rule 506(b) offerings where non-accredited investors are involved, the issuer is required to provide extensive information about the sponsor’s track record. Some version of that concept, applied consistently and allowing for side-by-side comparison, might be the most valuable information for investors.
Questions? Let me know.