Why IRR is Not the Rate of Return for Your Investment: Introducing AIRR to the Real Estate Community

Abstract

The internal rate of return (IRR) is used extensively in the real estate sector, notwithstanding certain nagging deficiencies taught in most business school texts, such as that the IRR may have multiple solutions which cannot be reconciled; or that it may lead to decisions that are not consistent with net present value. Unbeknownst to most practitioners, two of the more serious alleged deficiencies have been refuted in the last decade, seemingly great news for IRR advocates. However, the elimination of these deficiencies exposes a more fundamental criticism, one which is addressed in this article; and it is that the IRR is associated with interim project values that are implied by the IRR equation itself and almost surely differ from the true interim values of the project under consideration. To the extent that these values differ, the IRR result will not be an accurate rate of return. Furthermore, such values implied by IRR will almost surely contradict any estimated project values used for time-weighted rate of return (TWR) purposes. A new metric called AIRR (Average IRR) overcomes these criticisms and produces a correct (dollar-weighted) rate of return for a project. Furthermore, AIRR has none of the problems that IRR has; most importantly, its solution always exists and is unique.

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Research Papers in Economics

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Last time updated on 06/07/2012

This paper was published in Research Papers in Economics.

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