CAGR vs. IRR

In previous posts, I discussed how to calculate a property's compounded annual growth rate (CAGR). In this post, I'll show another way to compute the return derived from RE investments: the internal rate of return (IRR).

IRR, like CAGR, is a metric used in financial analysis to estimate the profitability of investments. The difference between the two is that IRR is more flexible than the CAGR. IRR computations produce a percentage (the "discount rate") that allows investors to compare investments. Technically, it derives the discount rate that makes the net present value of all cash flows equal to zero.

For example, a buyer wanted to purchase a Php10 Mn pre-selling lot that is turning over in 4 years. He projects that the property would appreciate 5% annually to Php12.155 Mn, at which point he'll sell.

The developer offered the buyer two payment schemes:

OPTION A - 8% discount on the price if he pays 100% upfront (the buyer had the money to do this)

OPTION B - A staggered payment schedule (10% down, 10% in 48 months, 80% on turnover)

Which option should he choose?

A CAGR computation would show that option A (CAGR of 7.2%) is better than option B (CAGR of 5.0%). This is because the initial outlay is smaller for Option A.

But doesn't the staggered payments count for something?

See, when CAGR is computed for most investments (e.g., stocks), it's calculated on the actual invested amount. For example, you have to own the stock to profit from it.

Conversely, a RE buyer (with a staggered payment schedule) earns even on the portion he hasn't paid for yet. When he sells the property, the developer doesn't say, "Hey, I want my 5% capital appreciation on the unpaid portion during years 1 to 3 because it's still technically mine." Moreover, the buyer could invest the remaining Php9 Mn in something else (e.g., time deposit/bond/etc.), thus further propping his return, right?

This is where IRR computations are helpful. IRR considers all cash flows for each year as opposed to CAGR, which merely looks at the beginning and ending values.

Anyway, an IRR computation for Option B produces a whopping 27% return vs. Option A's 7%. Put another way, the developer has to offer a ~54% discount to derive a similar return to Option B.

An IRR computation for Option B produces a whopping 27% return vs. Option A's 7%.

There are tons of YouTube videos on how to use Excel to calculate IRR. Or comment with a 👍🏻 below. If I get 50, I'll make a post on how to create your own spreadsheet.