1. Real Estate Finance, Spring, 2017
Parsing the IRR
Real Estate Finance, Spring, 2017

2. Introduction
When you are computing property-level IRR, it is useful to know
the part of the IRR from operating cash-flows (under manager control)
the part due to changes in cap rates (which are largely out of manager control)
We compute 3 pieces of a IRR
Initial Cash Yield
Cash Flow Change
Yield Change

3. Example Property bought at initial cash yield of 9%
Net cash flow increased at 2% per year
Property sold after 10 years at a terminal yield of 10% (based on year 11 projected cash flow = 2% more than year 10)
IRR is 10.30%
Question: How much of the IRR is due to
Initial Yield (IY)
Cash Flow Change (CFC)
Yield Change (YC)

4. Example (contd.)
To answer this, must normalize period 1 cash flow to $1
Given initial yield of 9%, purchase price was $1/0.09 = $11.11
With outlay of -$11.11 in year 0, cash flows give IRR = 10.30%
You should verify the normalization does not affect the IRR

5. Initial Yield (IY)
Net cash flow yield that was obtained in the first year of the investment, based on the purchase price.
Told initial yield was 9%
Thus, IY = 9%

6. Cash Flow Change (CFC) Return Component
IRR increment to initial yield caused purely by the actual change in cash flows over time
Procedure:
Compute IRR with same cash flows, but set terminal valuation cap rate equal to initial going-in rate
Set CFC = IRR computed in Step 1 less the initial yield

7. CFC Return Component
With outlay of -$11.11 in year 0, cash flows give IRR = 11.00%
CFC = 11% – 9% = 2%

8. Yield Change Component (YC)
Pure effect of a change in valuation yield
Based on what overall property cash flows would be if initial net operating cash flow had remained constant throughout the holding period, but yield changed as it actually did between initial purchase and resale
Procedure:
Compute IRR holding cash flows constant, but set terminal valuation cap rate equal to realized terminal valuation cap rate
Set YC = IRR computed in Step 1 less the initial yield

9. YC Return Component With outlay of -$11.11 in year 0, IRR = 8.32%

10. IRR Decomposition 𝐴𝑐𝑡𝑢𝑎𝑙=𝐼𝑌+𝐶𝐹𝐶+𝑌𝐶+𝐸𝑟𝑟𝑜𝑟
10.30%=9.00%+2.00%−0.68%−0.02%
Error is called the “Interaction Effect”