Glossary

Internal Rate of Return (IRR)

The internal rate of return (IRR) is the annualized discount rate at which the present value of an investment's future cash flows equals its initial cost, making net present value zero. It combines the size and timing of cash flows into a single annual return figure used to compare investments.

Formula

0 = Sum of CF_t / (1 + IRR)^t for t = 0 to n, solved for IRR

Example

An investor pays $1,000,000 for an asset that distributes $100,000 at the end of years 1 and 2, then $1,100,000 at the end of year 3 (a final $100,000 distribution plus $1,000,000 of sale proceeds). The discount rate that makes the present value of those flows equal $1,000,000 is exactly 10%, so IRR is 10%. If the same $1,300,000 total arrived in a single payment at year 3, IRR would fall to about 9.1%.

How it is used in underwriting

IRR is the headline return metric in private equity, real estate and project finance because it captures timing: money returned sooner produces a higher IRR. Underwriters build a cash flow model with the initial investment, interim distributions and exit proceeds, then solve for IRR. Investment committees compare the result with a hurdle rate or required return, and fund waterfalls use IRR thresholds to determine when sponsors earn promote or carried interest. Levered IRR includes debt flows and reflects returns to equity; unlevered IRR excludes financing and measures the asset's own performance.

IRR has well known weaknesses. It assumes interim cash flows can be reinvested at the IRR itself, which overstates returns on high IRR deals; modified IRR addresses this. Short holds can produce very high IRRs on small dollar gains, which is why investors pair IRR with MOIC or equity multiple. Cash flows that change sign more than once can produce multiple IRRs. Subscription lines and delayed capital calls can boost fund IRRs without improving actual profits. Lenders rarely rely on IRR; they focus on repayment capacity through DSCR, leverage and collateral coverage.

Typical benchmarks

Return targets vary widely by strategy. Core real estate investors often target high single digit IRRs, value-add strategies low to mid teens, and buyout or opportunistic strategies commonly target around 20% or more gross, though targets shift with interest rates.

Run the numbers: IRR Calculator

Frequently asked questions

What is a good IRR?

A good IRR exceeds the investor's cost of capital and compensates for the risk taken. Lower risk core real estate might target high single digits, while private equity buyouts often target 20% or more. Always compare IRR with the hold period and the multiple of money, since a high IRR on a short hold can mean little profit.

What is the difference between IRR and ROI?

ROI, or return on investment, is a simple ratio of profit to cost that ignores timing. IRR accounts for when each cash flow occurs and expresses the result as an annual rate. Two deals with the same ROI can have very different IRRs if one returns capital much faster.

Why can IRR be misleading?

IRR assumes interim cash is reinvested at the same rate, can be inflated by short hold periods or fund credit lines, and may produce multiple answers when cash flows change sign. It also says nothing about the dollar size of the profit. Pair it with MOIC, NPV and a review of the underlying cash flows.

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