What is an internal rate of return

April 25, 20224 min read
What is an internal rate of return
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Key takeaways

  • The IRR is a measure of investment performance commonly used by finance professionals to assess and compare different investment opportunities.
  • It is usually calculated through an Excel spreadsheet function and can be loosely defined as the annual rate of growth that an investment is expected to generate.
  • Financial instruments are inherently risky, and target investment goals can be missed in both public and private market investments.

What is an IRR

The targeted IRR – or internal rate of return – can be utilized as a standard metric to evaluate and compare different investment opportunities. Financial textbooks define it as the discount rate for which the net present value of an investment’s cash flows is equal to zero. In other words, if you discount the future projected income from an investment by the IRR, your investment returns would be equal to zero.

The tables below provide a more intuitive explanation. 

Investment A:

InvestmentYear 1 incomeYear 2 incomeYear 3 incomeYear 4 incomeYear 5 income

IRR = 6.67%

Investment B:

InvestmentYear 1 incomeYear 2 incomeYear 3 incomeYear 4 incomeYear 5 income

IRR = 6.89%

For both investments, the Year 1-4 cash inflows are the incomes generated each year by the investment. The last inflow is the principal – the value of the investment – at maturity plus the 5th income payment. 

Notice, however, that these two investments have different internal rates of return. The reason is the timing of the cash flows – for the second investment, earlier cash flows increase the compounding rate – and therefore final returns. 

The IRR value cannot be manually calculated. It is obtained by using a financial calculator, or an Excel formula. If you want to try it at home, here’s the Excel formula:

=IRR({-10000,700,500,700,750,10700}) for Investment A.

=IRR({-10000,1000,1000,450,200,10700}) for Investment B.

What are the benefits of using IRR

Calculating the IRR of an investment provides an intuitive way to compare potential returns with the prevailing risk-free rate, and quickly understand whether the allocation of capital is likely to offer positive returns. For instance, if the prevailing risk-free rate for an investor is 7%, neither investment A nor investment B appear to be viable options – rather, the investor will lend his money at 7% risk-free. Additionally, by comparing IRRs from different assets, the investor can decide which return is projected to be higher and select the likely best opportunity. 

This is usually easier said than done: in reality, most investors cannot lend at the prevailing rate – a bank normally lends money from investor deposits, earning the return and passing on just a fraction of it to its customers. But despite the practical blunders, the IRR remains a good benchmark to see if an investment is delivering, compared with other opportunities. 

It is important to remember that an IRR does not take into account the time value of money. Indeed the “risk-free” rate, which is the rate used to discount future cash flows, is the benchmark against which the IRR can be assessed. It is also worth mentioning that this metric provides only a snapshot of the expected investment performance, and does not give investors any indication of its volatility or price fluctuations.

Yieldstreet’s “target rate of return”

While investors or analysts can carefully vet the risk-return profile of an investment, and make a recommendation based on their best knowledge and information, the risk of the investment not performing according to projections is inherent to any investment opportunity – regardless of whether the allocation is in private or public markets. As we’ve seen repeatedly in the past, publicly traded stocks can go to zero, Argentina can default on a sovereign issue, oil can go negative and even the most respected names in the hedge fund industry can suffer heavy losses.  

As the investment memorandum for one of our real estate opportunities recites: 

“The target internal rate of return of investors in the Issuer (“Investors”) is {a certain percentage}, net of Management Fees, Flat Expense and structuring fees, with an expected {x} equity multiple…”

The IRR is typically just a target, a calculation based on cash inflows expected from a certain investment. 

As we mention in our investment documentation: 

Any projected return or estimate for an Issuer’s investment is only a target … The Issuer and the Manager have no way of knowing or predicting whether such target return is realistic and achievable or whether such return will ever be realized for an investment. 

While Yieldstreet cannot guarantee that investments will perform as expected, it has so far returned over $1.5 billion dollars, and the net annualized IRR of its matured investment as of April 2022 is 9.71%