Updated · Part of the CRE investment glossary
How IRR works
Every investment is a series of cash flows: money in (contributions and capital calls) and money out (distributions, refinance proceeds, sale proceeds). IRR is the single annual rate that, used to discount all of them back to the start, makes the total equal zero.
Discounting is what makes IRR sensitive to time. A dollar received in year 1 is worth more than a dollar received in year 5, so a deal that returns cash early earns a higher IRR than one returning the same dollars later. That is the difference between IRR and the equity multiple, which counts dollars only.
The formula
IRR has no closed-form answer. It is the rate r that solves this equation, found by iteration (a spreadsheet or calculator does this):
0 = CF0 + CF1 ÷ (1 + r) + CF2 ÷ (1 + r)² + … + CFn ÷ (1 + r)ⁿ
- CF0: the equity invested, entered as a negative number.
- CF1 … CFn: the net cash flow to equity in each period, including sale proceeds in the last.
- r: the IRR per period. With annual periods it is an annual rate.
Worked example: why timing matters
Three deals each take $1,000,000 and return $1,500,000 in total, a 1.50x equity multiple. Only the timing differs.
| Deal | Cash returned | Multiple | IRR |
|---|---|---|---|
| A | $1,500,000 at the end of year 5 | 1.50x | 8.45% |
| B | $1,500,000 at the end of year 3 | 1.50x | 14.47% |
| C | $300,000 in years 1 and 2, $900,000 in year 3 | 1.50x | 18.90% |
Annual IRR vs XIRR
Excel’s IRR function assumes equal periods with each cash flow at the end of a period. XIRR uses the actual date of each cash flow and a 365-day year. Real deals rarely move money on anniversaries: capital calls land mid-year and distributions are often quarterly, so the two can give different answers for the same deal.
Example: an investor funds $500,000 on March 1, 2024 and $500,000 on September 1, 2024, then receives $80,000 on March 1, 2025, $80,000 on March 1, 2026 and $1,250,000 on March 1, 2027. An annual model that puts both contributions at time 0 gives 12.99%. XIRR, which knows the second $500,000 went in six months later, gives 14.34%. For investor reporting, dated cash flows are the more faithful measure.
Common mistakes
IRR is easy to compute and easy to misread:
- Annualizing a quarterly IRR by multiplying by 4: 2.5% a quarter is 10.38% a year, not 10%. Compound it: (1 + quarterly rate)⁴ − 1.
- Reading IRR without the multiple: a short deal can post a high IRR on very little profit.
- Ignoring sign changes: cash flows that switch between negative and positive more than once (for example, a mid-hold capital call) can have more than one IRR.
- Comparing gross and net: a deal-level IRR before fees and promote is higher than the limited partners’ net IRR.
- Treating a projected IRR as a promise: it is not guaranteed and rests on the sale price and timing assumed.
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.