The main purpose of this detailed technical section is to provide you, the LP investor, with a basic understanding of underwriting terminology before your next investment decision. While we don’t expect all passive investors to master professional underwriting skills, our goal is to familiarize you with key concepts and nuances. This knowledge will enable you to engage in conversations at our future events and effectively communicate with professional underwriters, aiding your own thorough due diligence process.

At a basic level, investors should understand terms like cap rate, average occupancy rates, and typical fee structures. This foundational knowledge is crucial but beyond this, a more advanced understanding involves analyzing profit and loss statements, rent rolls, and utilizing robust tools like a multifamily commercial real estate analyzer. While we don’t expect all investors to reach this level of expertise, we do encourage you to join our Deal Desk group for practical experience with real-world alternative investments.

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What is the Internal Rate of Return (IRR)

IRR is the most used calculation in private equity real estate investments, but what exactly is IRR?

The IRR (internal rate of return) is a time-weighted return metric that is common in both financial accounting and real estate investing, where the time value of money and liquidity risk are major factors in investment strategy. IRR represents how long it will take for your money to be returned over time and it shows how hard your money is working.

IRR vs ROI

IRR can get mixed up with return on investment (ROI), the difference can be best explained with an example. If you invested $100,000 into an alternative investment and received $300,000 in return, you would likely think that’s a good investment since it’s a 300% return on investment (ROI).

However, if it took 20 years to get $300,000 then that would be a 5.65% compound annualized return (IRR). This is the main flaw of ROI – it doesn’t account for the time period that it takes for you to receive distributions.

Comparing IRR Between Investments

IRR is not always useful as an apples-to-apples comparison between two equity investments. If two equity investments have two different target hold periods and different business plans, IRR may not be a useful device for assessing which is the more appealing investment. Combine these two different asset class/business plans with different tax implications and you can see where it makes comparing two investments very difficult.

Take the example of two hypothetical realized investments:

Value-add Investment A

A common equity investment into a value-add redevelopment and repositioning of a Class C multifamily property.

The General Partner expects to execute an aggressive project improvement plan, bring rent rolls positive, and exit through sale after a 3-year hold.

The General Partner expects to earn the vast majority of profits through exit and ultimately hopes to achieve a project-level IRR that would result in a net 20% IRR to LP investors on the investment opportunity.

Value-add Investment B

A portfolio company of mixed assets, primarily in gateway markets, stabilized (defined as 90% occupied or more in multifamily apartments), and yielding present cash flow.

The asset managers of the portfolio expect to achieve cash flow and make distributions throughout the term of the project amounting to an annual average of 9% per year across a 10-year holding period with a modest exit resulting in a net 10% IRR to LP investors.

If these two investments play out as intended, the projects will yield a net 20% IRR and a net 10% IRR to LP investors, respectively. However, this does not mean that the former value-add project is 2 times as good as the latter portfolio investment. Which one is more appealing, and to what degree, depends on the preferences and strategy of the investor evaluating these two opportunities.

To see the difference in person between a B vs C class location and asset cannot be replaced… but once you do you never have to do that again! 😁

We recommend investors come out on at least one property tour to see the assets and meet the people. That said most busy LPs will not come out to visit the properties which is why this numbers section is so critical.

Conclusion and Key Takeaways

Passive Investing Still Requires Active Learning – While LPs aren’t expected to underwrite deals like professionals, having a working knowledge of underwriting terms and key metrics (like cap rate, IRR, and rent rolls) makes it easier to ask the right questions and spot red flags.

Understanding IRR Prevents Misleading Comparisons – IRR accounts for the timing of cash flows, unlike ROI. A 300% ROI over 20 years is not the same as a 300% return over 3. IRR gives a more realistic picture of how efficiently your capital is working over time.

ROI Looks Impressive, But IRR Tells the Real Story – Just because a deal triples your money doesn’t mean it’s great. If the cash comes late in the project’s life, the actual annualized return (IRR) may be underwhelming.

Different Deals, Different Goals – A value-added deal with a short hold and backloaded profits may show a high IRR, but a stabilized deal with consistent income and a longer hold may be more aligned with an investor’s cash flow needs. Know what you want before comparing numbers.

Site Visits Are Optional, But Numbers Aren’t – Most LPs won’t fly out to see properties, which is why learning how to read P&Ls and analyze deals with tools like a multifamily analyzer is so important. You can’t outsource common sense.

Useful Tools and Resources Are at Your Fingertips – Websites like city-data.com, SpotCrime, and GreatSchools.org can help you independently vet a deal’s location. Pair those with internal deal documents to round out your due diligence.

Join Groups to Sharpen Your Skills – Participating in communities like a Deal Desk can fast-track your learning and give you a chance to evaluate real deals alongside experienced investors, which is the best way to build confidence and competence.

This is educational content, not tax, legal, or investment advice. We are not attorneys, CPAs, or financial planners. Please let us know if you need a referral to a 💼 CPA, ⚖️ Lawyer, or other vendor here.

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