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Some thoughts in IRR in our investment world

IRR is probably a metrics used more used by business managers to evaluate a rational return so that they can estimate the margins that they can earn, the interest financing upper bound they need to keep down to.

IRR tries to force the net present value of the asset/security to zero.

An IRR of 10% on a property with a land lease of 20 years means that for 20 years the annual returns on the property is 10% for 20 years.

The higher the IRR the better, all else being equal.

Plan business decisions

If you know the IRR is 10%, you can go ahead to think realistically:

  • if you have floating rate financing at 2% for 8 years what is your return
  • In worse case if its fixed rate at 4.5% for 8 years what is your return
  • what are the additional “costs” that can be embedded in it

The risks of trusting IRR

IRR is rather bullshit in a lot of things because it suppose to be forward looking. You give an IRR of a toll road of 13% for the next 16 years with historical data. If you purchase based on that premise, you have to wonder how conservative is the assumptions in the estimates.

Most of the time, the product sales man provides an IRR of 20% to the private equity investors, because, if its less, they wouldn’t invest in the first place.

Longer payback

In a private equity deal, the investors look for a payback of 13% in 8 years. Things don’t usually  work out. A bear market makes realization (in a lot of case it is when the assets get IPO) difficult. It takes longer than 8 years. Their IRR goes down in that case.

Comparing between assets

As an investor, if you have a sensible IRR to work with, you can measure against comparable, all things equal.Suppose you have a shophouse with a fixed land lease, a growth rate that you can conservatively estimate, an IRR can be computed. You can measure it unleveraged (with no debts) against:

  1. your fixed deposit at 1%
  2. the REIT unleveraged return at 4%
  3. a ship IRR at 18%
  4. long term Singapore index at 6-7%
  5. the 10 years SGS government bond at 2.3%

You get a rough idea, perhaps the risks not stated does not constitute a good return if the unleveraged IRR is just 2.5%, since the risk free SGS government bond is at 2.3%.

Assessing management

Management makes acquisitions all the time and metrics like IRR, ROA and Acquisition price to EBITDA, earnings make good areas to see if the management is making right moves. It will also be good to generate questions for AGM how they intend to improve the ROA.

Else you will have a situation of an OPTUS purchase generating like 4-5% ROA.

Which is better

If we have Asset A with an IRR  of 12% with a 1 year duration versus Asset B with IRR of 10% with a 100 year duration, Asset A makes a better investment.

The problem is that most would go for Asset B since, 10% ain’t that bad and you get that for 100 years.

For a 1 year duration you probably one something returning much more.

You have a question in your head if the management can consistently replenish the expiring 1 year asset  at the same if not higher IRR.

Its an ongoing debate considering unleveraged, would you get a 4% REIT that have an average land lease of 40 years or a 18% IRR ship with a 20 year life span.

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JW

Tuesday 1st of April 2014

IRR is not bullshit, its one of many metrics (money multiple & payback period) that is used by PE.

Just like all metrics, garbage in garbage out. Doesn't matter if its DCF, NPV, its all the same. IRR is no different.

Kyith

Tuesday 1st of April 2014

Ah yes. U take it as if I was referring to every aspect. If it's total bullshit I wouldn't have discussed it

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