Capital punishment: The abuse and misuse of the IRR and NPV
Most real estate investors rely upon one or, at best, a few metrics to gauge the merits of a transaction or a portfolio of potential transactions. The internal rate of return (IRR) is perhaps the most popular metric but, compared to the net present value (NPV) criterion, it is flawed. The IRR method may lead to inconsistent project rankings and value-destroying investment decisions.
The NPV criterion is superior to most other investment criteria, including the IRR. The NPV and the IRR may not give consistent rankings. For example, an investment may have a superior IRR even though, given the appropriate cost of capital or discount rate, that investment has an inferior NPV. Some investors implicitly recognize this point by focusing on equity multiples.
The NPV is the sum of the discounted cash flows of a project. The proper way to calculate the NPV is to discount free cash flows at the project’s weighted average cost of capital (WACC). WACC reflects the c