Measuring Returns: Understanding How IRR Works
If you’ve spent any time looking at real estate deals, you’ve seen a slide screaming: “Projected IRR: 16%.” It sounds impressive, but on its own it doesn’t tell you whether the deal is conservative, aggressive, or even realistic. To make smart decisions, you need to understand what’s behind that number instead of taking it at face value. To be a serious real estate investor you must understand how IRR works, what it really measures, and where it can mislead you. Once you understand it, you’ll spot overhyped projections much faster and feel more confident comparing deals. IRR becomes a decision tool instead of a sales tactic.
IRR stands for Internal Rate of Return. In simple terms, it is the annualized rate of return that makes the net present value (NPV) of all your cash flows equal zero. Said another way, it is the discount rate at which the present value of every dollar going into the deal equals the present value of every dollar coming out.
In plain English, IRR is the average annual return your money earns after accounting for the timing of every cash flow. It does not only care about how much profit you make; it also cares about when you receive that profit. That timing factor is exactly what separates IRR from simpler return metrics.
Two deals can create the same total profit but have very different levels of attractiveness. Imagine one deal where you invest today and receive nothing for five years, and another where you get steady distributions plus a sale at the end. Both could produce $100,000 in profit, but the second deal is usually more appealing because you receive part of your return earlier and can reinvest it.
IRR captures this difference by valuing earlier cash flows more heavily than later ones. When you receive more of your money sooner, the IRR is higher because your capital is working harder over time. Understanding this is crucial if you want to compare deals with different hold periods, cash flow patterns, or exit strategies.
To calculate IRR in a real estate investment, you need a series of cash flows over time. These are not just the initial investment and the final sale; they include everything that happens in between. The pattern and timing of these cash flows are exactly what IRR is measuring.
For a typical multifamily deal, that cash-flow stream usually includes:
Your initial equity investment (a negative cash flow at time zero)
Ongoing distributions from cash flow operations
Refinance proceeds that may return some or all of your capital
Final sale proceeds at the end of the hold period
You feed this timeline of cash flows into a spreadsheet and use the IRR function to calculate a single annualized percentage. You do not need to solve the equation manually, but you do need to understand what assumptions are going into the projection. If the cash flows are overly optimistic, the IRR will be inflated and misleading.
Let’s look at a simplified example to see how IRR reacts to timing. Suppose you invest $100,000 in Deal A, receive no cash flow for four years, and then get $200,000 back in year 5. You doubled your money over five years, which sounds like a 20% simple average return per year, but the actual IRR is lower because all the profit arrives at the end.
In this case, the IRR is around 14-15%, not 20%, because your money sat idle in terms of distributions until the final year. IRR “understands” that waiting five years for the payoff is not the same as earning profit steadily every year. The longer your money is locked up without cash flow, the more IRR penalizes the deal.
Now imagine Deal B, where you again invest $100,000, but this time you receive $10,000 per year in years 1–4 and $160,000 in year 5. You still receive $200,000 total, so the profit is the same, but part of it comes earlier. In this scenario, the IRR is higher than in Deal A because you started getting your return right away instead of waiting until the end.
IRR is powerful, but it should never be the only number you look at. To actually evaluate a real estate deal, you need to understand how IRR compares to other key metrics. Each metric tells you something different about the investment.
Cash-on-cash return measures annual cash flow divided by your total cash invested. For example, if you invest $100,000 and receive $8,000 per year in distributions, your cash-on-cash return is 8%. This metric tells you how much income you receive relative to your investment each year.
However, cash-on-cash does not account for the sale proceeds or refinance events. It also does not consider the timing of when your capital is returned. That means it is great for judging ongoing income, but incomplete for evaluating the full life of the deal.
Equity multiple measures total cash received divided by total cash invested over the entire hold period. If you invest $100,000 and eventually get back $220,000, your equity multiple is 2.2x. This shows how effectively the deal multiplied your original capital.
The equity multiple is excellent for understanding the total wealth created, but it ignores how long it took to achieve that result. A 2x multiple over three years is very different from a 2x multiple over ten years. Equity multiple alone cannot tell you how efficiently those returns were generated.
IRR captures both the magnitude and the timing of all cash flows. It incorporates annual distributions, refinances, capital returns, and the sale into one annualized percentage. This makes IRR ideal for comparing deals that have different timelines or different patterns of cash flow.
The best approach is to use all three metrics together. Cash-on-cash tells you about income, equity multiple tells you about total wealth created, and IRR tells you how efficiently that wealth was produced over time.
One subtle feature of IRR is how sensitive it is to the length of the hold period. Shorter holds can show very high IRRs even if the absolute dollar profit is modest. Longer holds may show slightly lower IRRs but still create more total wealth and sometimes involve less execution risk.
For example, imagine you invest $100,000 and receive $130,000 back after two years. You made $30,000 in profit, which is not life-changing, but the IRR looks attractive because it happened relatively quickly. If the same $30,000 profit occurred over five years instead, the IRR would be much lower even though the total profit is identical.
This is why you should always pair IRR with the hold period and equity multiple. A very high IRR on a short flip might involve more risk, more debt, or more aggressive assumptions than a slightly lower IRR on a stable, longer-term hold. It is not just about the percentage; it is about the story behind it.
IRR is only as honest as the assumptions used to calculate it. Sponsors can easily make a deal look great on paper by tweaking a few key variables. As an investor, you should know the most common ways IRR can be unintentionally—or intentionally—misleading.
If a sponsor assumes the property will sell at a very low cap rate in the future, the projected sale price—and therefore the IRR—can look amazing. However, that assumption might not be realistic for the market or economic environment. Conservative modeling usually assumes an equal or slightly higher exit cap than the entry cap to allow for softening conditions.
Some pro formas show large refinance events that return 50–70% of investor capital in year two or three. While this can happen in certain markets, it is far from guaranteed. You should always examine the assumed loan terms, DSCR, and valuation that enable that refi, and ask what happens to IRR if the refinance is delayed or the proceeds are smaller.
Occasionally, deals are structured so that early fees or one-time payouts juice the IRR, while long-term cash flow is underwhelming. The headline number looks great, but the actual passive income is disappointing. This is why you should study the year-by-year cash flow table instead of relying only on the final IRR slide.
A 17% IRR on a three-year deal and a 15% IRR on an eight-year deal may sound comparable, but they represent very different risk and return profiles. The shorter deal exposes you to more transaction risk and requires you to find another good investment sooner. The longer deal may compound wealth more quietly while offering fewer taxable events and less turnover.
There is no universal “right” IRR number, because asset class, market risk, and business plan all matter. A conservative deal in a core market will naturally project a lower IRR than a heavy value-add project in a volatile area, even if both are solid investments for the right person. You always need to interpret IRR in context.
Broadly speaking, core or low-risk deals might target IRRs in the high single digits to low teens. Value-add multifamily deals often target IRRs in the mid-teens to low twenties, reflecting both the upside and the execution risk. Opportunistic or heavy lift projects may project higher IRRs, but they come with greater uncertainty and more ways for the plan to miss.
Instead of asking, “Is this IRR good?” ask, “Is this IRR realistic for the risk and story of this particular deal?” Compare it to similar offerings in similar markets, and make sure it aligns with your personal goals and risk tolerance.
When you understand how IRR works, you can use it as part of a repeatable review process. Instead of being dazzled by a single number, you walk through the deal with a checklist. That mindset shift alone will save you from a lot of disappointing investments.
Here is a simple way to evaluate IRR in context:
Check the Hold Period
Look at how long the deal is projected to run. A 3-year IRR and a 7-year IRR should not be compared blindly, because the risk and reinvestment requirements are very different.
Look at the Equity Multiple
Compare IRR to the total equity multiple. Ask yourself whether the projected annualized return is actually creating enough total dollars for the amount of time and risk involved.
Study the Cash Flow Pattern
Review the pro forma to see whether returns come from steady cash flow, a big refinance, or a large back-end sale. Make sure that pattern matches your needs for income and liquidity.
Stress-Test Key Assumptions
Ask what happens to IRR if the exit cap is higher, the refinance is smaller, or rent growth is slower. If a small change destroys the IRR, the deal may be too fragile.
Compare to Other Opportunities
Evaluate multiple deals side by side using IRR, equity multiple, cash-on-cash, and qualitative factors like sponsor track record and market quality. You are not just picking a number; you are choosing a business plan and a team.
IRR is one of the most useful metrics in real estate investing, especially for multifamily and longer-term projects. It helps you compare deals with different timelines, cash flow patterns, and exit strategies in a more sophisticated way than simple ROI. When used correctly, it gives you a clearer view of how efficiently your capital is working.
However, IRR is not a crystal ball and should never be treated as the single source of truth. It is only as accurate as the assumptions and cash flows behind it, and it can be easily distorted by aggressive modeling. The real power comes from using IRR alongside cash-on-cash return, equity multiple, and sound judgment.
When you combine a solid understanding of how IRR works with conservative underwriting and a strong investing framework, you move from guessing to truly measuring returns. That’s when you stop chasing shiny numbers and start building a portfolio that actually supports your long-term goals.
IRR, or Internal Rate of Return, is the annualized rate of return that makes the net present value (NPV) of all cash flows in a deal equal zero. In real estate, that means IRR looks at every dollar going into and out of the investment—including the timing—and solves for a single yearly return. It helps you compare deals that have different cash flow patterns and hold periods on a consistent, apples-to-apples basis.
Simple ROI usually looks at total profit divided by your initial investment and often ignores the timing of cash flows. For example, doubling your money over 2 years and doubling your money over 10 years both show 100% ROI, even though they are very different outcomes. IRR, on the other hand, bakes in when you get your money back, so a deal that returns capital and profit earlier will show a higher IRR than one that keeps you waiting.
Timing matters because money you get back earlier can be reinvested into other opportunities, which increases your long-term wealth. IRR recognizes that a dollar received today is worth more than a dollar received five years from now. When you understand how IRR works, you see that deals with strong early cash flow and earlier capital return are often more attractive than deals that pay nothing until the end, even if the total profit is similar.
To understand how IRR works in a real estate investment, you need to look at the full sequence of cash flows, typically including:
The initial equity investment (money you put into the deal)
Periodic distributions from cash flow operations
Refinance proceeds that return some or all of your capital
Final sale proceeds when the property is sold
All of these flows—both negative (invested) and positive (received)—are plugged into an IRR calculation. The IRR is the discount rate that makes the present value of the positive and negative cash flows balance out to zero.
There is no single “good” IRR number because it depends on the risk level, business plan, and market. Generally, a higher IRR suggests your money is working harder, but it often comes with higher risk or more aggressive assumptions. The key is to compare IRRs within the same risk category and alongside other metrics like equity multiple and cash-on-cash return, so you are not just chasing the highest percentage without understanding the story behind it.
Cash-on-cash return tells you how much annual income you are receiving relative to your investment, while equity multiple tells you how many total dollars you get back compared to what you put in. IRR combines both ideas by looking at total profit and the timing of all cash flows. When you know how IRR works, you use it together with cash-on-cash and equity multiple rather than relying on any single metric in isolation.
Yes, it can. IRR can look fantastic on paper if the projections assume aggressive exit cap rates, optimistic refinance events, or unrealistic rent growth. If you do not understand how IRR works and what cash flows went into the calculation, you may be impressed by a high number that is built on fragile assumptions. Always look at the underlying pro forma and stress-test it before trusting the headline IRR.
Shorter hold periods can produce very high IRRs even if the absolute dollar profit is modest, because the return is compressed into a shorter timeframe. Longer holds may show slightly lower IRRs but still create more total wealth and sometimes come with less execution risk. When you understand how IRR works, you always pair the IRR number with the hold period and equity multiple to get the full picture.
First, make sure each deal’s IRR is based on a realistic set of assumptions. Then compare:
The IRR for speed and efficiency of returns
The equity multiple for total wealth created
The cash-on-cash for ongoing income
The hold period and risk profile
When you understand how IRR works, you see it as one piece of a decision framework. You are not just asking “Which IRR is highest?” but “Which IRR makes the most sense given the risk, business plan, and my personal goals?”
You don’t need to solve the IRR equation by hand, because spreadsheets and calculators can do that for you. What you do need is a conceptual understanding of how IRR works and what goes into it. If you know which cash flows are included, how timing changes the result, and how assumptions can skew the number, you’ll be able to use IRR wisely without being a mathematician.
Disclaimer: This article was written with the help of AI and reviewed by Rod and his team. Always consult a licensed professional.
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