AAR Vs. IRR: Multifamily Real Estate Terms Investors Must Understand

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aar vs. irr

Looking at multifamily real estate investment deals have always been an exhaustive task as it involves scrutinizing minute details and a sneak peek into the future projections. There are various ways of investing and generating returns but when it is about investing in multifamily real estate, it generally is about long-term benefits in terms of Return On Investment (ROI), keeping your equity safe against inflation and paving the way for growth of your financial portfolio.

While investors are looking at a number of dynamics of investing and leveraging a multifamily real estate deal at a single moment of time, they might overlook one important aspect i.e. their dollars bringing in the high returns even in the future when inflation tends to reduce the purchasing power.

A pro investor knows that reading a real estate investment offering includes its own unique metrics. Added to that, each investment is different, and there is not a uniform procedure for your investment to start out. It always helps to know the key measures to weigh your investment options against certain parameters such as profitability, potential returns on a property, annual cash flow and many more.

One of the crucial things to take in account is the real estate deal’s IRR (Internal Rate of Return) and AAR (Annual Average Return). There are many commercial real estate valuation methods but if you have a solid understanding of the term AAR and IRR, it can help you have apple to apple comparison. For a more critical view, IRR is a preferable benchmark.

AAR is an indicator used to evaluate an investment over time. It gives the view of average real estate return on investment. The calculation for the AAR involves averaging annual cash-on-cash returns (CCR) of each year.

To get your overall returns, you divide your actual cash out of the investment each year i.e., profits after deducting operating expenses and mortgage payments, by your original finance (equity).

Illustration:

 Investment (in $)Year 1Year 2Year 3Year 4Year 5
Equity Contribution250,000    –    –    –    –    –
Operating Cashflow      –15,00015,00015,00015,00015,000
Net Sale Proceeds      –    –    –    –    –300,000
Cash-on-Cash Return      –6%6%6%6%126%
Annual Average Return30%     

While IRR is also used to determine if an investment is performing efficiently, it is calculated by using a different method than the one used to calculate AAR. IRR takes into account the time value of money. It considers the understanding that you will be reinvesting so that you hold the value of your dollars against inflation.

This example above illustrates AAR (Annual Average Return) 30%. While the IRR (Internal Rate of Return) would be only 9.4%. This value would be much less than the annual average return of 30%.

So, what do you prefer, IRR or AAR?

AAR doesn’t take into effect how valuable a dollar now is as opposed to how much it’s worth in the future. Inflation can also impact the dollar’s value, which makes it worth less as time passes. However, if you invest that dollar today, you will have a higher return on it in the future.

Some real estate syndicators present their returns using only the Average Annual Return (AAR), one out of various methods of deal valuation. AAR and IRR, both of these ways are typically used in financial settings and they can appear very similar. So, be sure you are not just considering an investment with X percent AAR but you are also checking the IRR.

The calculations differ slightly, though IRR is probably a better measure from which to make your investment decisions. We recommend choosing IRR, as it offers a more in-depth view of potential returns. When seeking investment opportunity, be sure to inquire about the IRR and look out for operators who are hesitant to offer this info. Have the person answering the question explain the IRR for this investment so you can get a thorough understanding of whether it’s advantageous for your investment in comparison with others.

Also read: Multifamily Real Estate Investing FAQs Answered

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Fair Winds Capital Investments is a veteran owned and operated firm dedicated to providing safe and exceptional quality housing to our tenants. We aim to provide our partners with a shared ownership platform of low-medium risk alternative investments throughout the Southeast, with a partnership preference given to our fellow Servicemen seeking to add a diverse and bolstered income stream.

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