047: Looking into the Future: AAR vs. IRR
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First things first, we are so grateful for our incredible community of friends and followers who tune in each week, and if you’re new here– welcome! We’re Palmy and Nancy Kitti, AKA the Kitti Sisters, and we like to consider ourselves financial BFFs for high-level entrepreneurs.
And speaking of friendship, a big part of being a good friend is actually telling your friend’s secrets. 🤫🤫
You remember the good ol’ sleepover secret, right? The pizza, the truth or dares, the seance someone inevitably starts. Sometimes, in the world of apartment syndication, it can feel like a little bit of an exclusive sleepover invite. There’s a lot of insider language and confusing abbreviations. No one is trying to bring back the dead, thank God.
But people might try to scare you with all of this insider lingo that can make you feel left out, and that’s a feeling we don’t want for anyone.
That’s why today, as your financial BFFs, we’re letting you in on knowing and understanding the difference between two common terms your sponsorship team might use to indicate how much a passive investor would make. 🤓🤓
Maybe you’ve already heard of them, and those two terms are called AAR and IRR 👉 AAR stands for Average Annualized Return and IRR stands for Internal Rate of Return.
Both measure the ROI– return of investment.
We hope we haven’t lost you with all of these abbreviations, stick with us we promise it gets better. Especially since these are calculations and terms that will help you navigate how much you’re getting back in your pocket.
Here’s what we know about you. You’re a savvy investor always on the hunt to pursue knowledge. As we like to say– you know just enough to be dangerous. And that translates across everything you do, not just investing.
That’s why knowing the difference between these two terms is crucial. In this deep dive explanation, we’re about to get into, you’ll be able to not just understand these terms, but what they measure, and how to use them when vetting potential deals.
So pass the pizza and get comfy because we don’t keep secrets here!
AAR
Let’s kick things off with AAR, the average annualized return. The AAR is a simple equation used to calculate the average amount of money an investment earns each year. AAR is calculated by taking the total ROI and dividing it by the years of investment.
Let’s take a pause here because we don’t want to freak 😱😱 anyone out with all of this talk about calculations. It’s pretty obvious that math is a part of the deal when it comes to being in the investor world, so we’ll give you some practical examples to help you follow along.
Here’s the FORMULA for the AAR: AAR = Total ROI divided by the number of years of investment.
For example, let’s say you invest $100,000 in an apartment syndication that you totally love, has been vetted, and you’re excited to get moving on. Your sponsorship team tells you that the total ROI provided to you is $72,000 over four years.
Seems pretty straightforward, right?
So that means the AAR = $72,000 divided by 4 years = $18,000 average annual return. This is a high-level estimate of what you would earn each year that your money is tied into the multifamily project.
Typically, when being presented with an investment opportunity by a syndicator, they will give you an AAR as a percentage.
For example, you may be looking at investing $100,000 in a deal that has a projected 20% annual return.
So, what does that mean for you? Let’s do the math: 18% of $100,000 equals $18,000 a year. 🤔🤔
Now, the term “each year” can get a little tricky here, especially if you’re investing for equity growth. In that case, you may not see that $18,000 in your bank account each year. It’s more likely you will get a lump sum payout at the end of the deal lifecycle that adds up to an AAR of $18,000 per year– but all paid at once.
So if the lifecycle is 4 years, that means it’ll be $18,000 times 4, totaling back to your original $72,000.
Of course, each deal and each percentage is different. So what are we to look for in today’s market?
16% or higher is generally considered a good AAR for a stabilized property needing light, cosmetic upgrades. Nothing to bust out the sledgehammer for, but maybe a fresh coat of paint and upgraded smart locks. ☺️☺️
On the flip side of that, if an apartment needs a little extra TLC, heavier value-add projects should be at 16% or higher. As for apartments that need all new construction, that rate should be above 18% due to the higher risk and lack of cash flow.
AAR is very popular amongst a lot of apartment syndicators, but we prefer the IRR route. Which, we’ll get in a sec, and here’s why:
Let’s say you’re comparing two properties.
Property A requires a five-year investment with 100% ROI.
Property B requires a 10-year investment with a 200% ROI.
When you do the math, both properties yield a 20% AAR. 100% divided by 5 years and 200% divided by 10. But there is a significant difference here– time. Property B holds up your money for double the time property A does.
While you’re considering AAR, know that AAR is not considering an array of factors that can arise from this long time horizon. We’ve all been a witness to these past two years, and now you’re talking ten?! That’s a lot of faith in father time to not mess with your investments.
These factors include inflation, time, and opportunity cost. These additional costs could result in significantly lower real returns, which is never good. Of course, you’re smart and you’d choose the 5-year property, which is why it is critical to understand IRR, not just AAR, when vetting deals.
IRR
And speaking of IRR, shall we get into the details?
IRR stands for internal rate of return. The IRR still measures the annual return buuuut it’s a lot more complicated an equation that offers a deeper dive into the potential returns on investment.
The other major difference between AAR and IRR is that IRR takes value time of holding into account. Which for us is a major plus. We’re of the belief that using AAR alone is too simplistic, leaving out the reality of today’s dollar 💲 value and the longevity of the deal.
In this economy, we need all the security we can get as investors. And sometimes it can feel like playing a game where the rules change at every move. Not fun, and completely unpredictable.
Using IRR allows investors to truly compare apples to apples. While the math may be more complicated, it’s also more exact so investors can make a more informed decision.
A note here: as a passive investor, you wouldn’t need to do the math yourself, when you’re reviewing an investment opportunity, your sponsorship team will say hey, the AAR here is 20% and the IRR is 16%.
So what’s involved in this IRR calculation? A few things. IRR takes into consideration the level of annual distributions for investors, the date that the property will be sold, and the price the property is expected to sell for in order to calculate the total projected return.
All of these factors take into account what AAR does not and because of that, you may actually see that the estimated IRR of a project is lower than the estimated AAR.
So what is this complex formula? I mean, it’s nothing Einstein level but it does require the same formula as Net Present Value, also known as NPV does. This is because the IRR is in fact the discount rate that would make the NPV of an investment equal to zero.
But here’s the good news, as a passive investor you don’t have to worry about this too much. This is where your sponsorship team comes in and does the job for you!
Let’s get into the numbers. If you’re listening, we’ll put these calculations in the show notes of our website 👉 thekittisisters.com/podcast. Let’s use the same numbers from the AAR example and compare the IRR of the same project with identical cash returns.
For sure, so let’s say the initial investment is $100,000 for easy math. Each year for five years your cash return is $20,000 until year 5 hits. In year 5, you’re making $100,000 making your ROI totaling $100,000. At an 20% IRR and AAR rate.
In this example, the returns from the investment are evenly distributed over the course of the years, which is why AAR and IRR are the same.
Now, if the cash returns from the investment are distributed in different increments with more being returned in later years. Since IRR takes into account timing, the IRR is now lower than the AAR.
Let’s look at this example again, except this time the IRR is at %16.81 percent. $100,000 over the cost of 5 years. So year 1 you’re making $7,000, year 2 is $10,000, year 3 is $20,000, year 4 is $24,000 and year 5 is $129,000.
In this case, the IRR is technically lower than the AAR (16.81% vs 18%) because more of the cash is received in the later years and the IRR calculation takes this into account whereas AAR does not.
But none of this answers the question, what is considered a “good” IRR?
Currently, since the date of recording this podcast, a good IRR for a low stabilized multifamily syndication that needs a little facelift with value-add play would be 13-14%. A healthy IRR for heavier value-add properties (like full-blown cosmetic surgery) would fall around 15% while new construction should be 16% or higher. ✅
We’re not math teachers, but hopefully, you’re starting to see the difference IRR and AAR are two commonly used calculations when it comes to multifamily syndications. Both measure the investor’s estimated return on investment but with very specific differences.
Our recommendation? Stick to IRR as it offers a more detailed look at the potential profit. 🙌🙌
While no one can see into the future, you will be able to determine how much annual cash flow distribution from your investment will be coming so that you hit your Freedom Metric ASAP. ✨
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