Average Annual Return, CAGR, and How to Calculate IRR

Book: Real Estate by the Numbers | Authors: J Scott and Dave Meyer | Chapters: 20-22

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The metrics in the last post (ROI, EM, cap rate, COC) are all useful, but they share one significant flaw: most of them don’t properly account for time.

Put $1,000 in a bank account and let it grow to $1,100 in one year. Or let it grow to $1,100 in two years. In both cases, the profit is $100, the ROI is 10%, and the equity multiplier is 1.1. The metrics can’t tell the difference.

But you can tell the difference. Waiting an extra year for the same result is not the same deal.

This is why we need time-sensitive metrics. These chapters cover three of them: average annual return (AAR), compound annual growth rate (CAGR), and internal rate of return (IRR). They get progressively more sophisticated, and each one solves a limitation from the previous one.

Average Annual Return (AAR) - Chapter 20

AAR is the simplest way to factor time into a return calculation. You just take the individual annual returns and average them.

AAR = (ROI Year 1 + ROI Year 2 + … + ROI Year N) / Years Held

The book uses an example of a $10,000 stock portfolio held for nine years with very volatile returns. Over those nine years the annual returns were: 15%, 18%, -12%, -9%, -5%, -12%, 20%, 15%, 12%.

AAR = (15 + 18 - 12 - 9 - 5 - 12 + 20 + 15 + 12) / 9 = 42 / 9 = 4.67%

This tells you the investment was growing roughly 4.67% per year on average. That’s more useful than just saying ROI was 40.41% over nine years, because now you can compare it to other investments on an annual basis.

The Limitations of AAR

AAR has two real problems.

Problem 1: It distorts negative returns.

Say an investment gains 20% in Year 1, then loses 20% in Year 2. Many people assume that cancels out to zero. But it doesn’t.

Starting with $10,000:

• After Year 1 at +20%: $12,000
• After Year 2 at -20%: $9,600

You lost money. But the AAR calculation says:

AAR = (20% - 20%) / 2 = 0%

AAR says you broke even. The actual numbers say you lost $400. A 20% drop hits harder than a 20% gain helps, because the drop is calculated on a larger base.

Problem 2: The spread of returns matters, but AAR ignores it.

The book shows four scenarios, all starting at $100,000 with a 10% AAR:

• Scenario 1: 10%, 10%, 10% each year → ends at $133,100
• Scenario 2: 15%, 10%, 5% → ends at $132,825
• Scenario 3: 20%, 10%, 0% → ends at $132,000
• Scenario 4: 30%, 0%, 0% → ends at $130,000

Same AAR, different ending values. Scenario 1 is objectively the best of the four, but you wouldn’t know that from AAR alone.

AAR gives you a quick approximation and it’s genuinely useful for fast comparisons. But be careful using it when there are negative return periods or highly variable annual returns.

Compound Annual Growth Rate (CAGR) - Chapter 21

CAGR is a more accurate version of an annualized return. Instead of averaging returns linearly, it asks: what single consistent growth rate would take you from the starting value to the ending value over this number of years?

CAGR = (Ending Value / Starting Value)^(1/n) - 1

Where n is the number of periods (years).

Using the same nine-year stock portfolio example with $10,000 starting and $14,041 ending:

CAGR = ($14,041 / $10,000)^(1/9) - 1 = (1.4041)^0.1111 - 1 = 3.84%

Recall that AAR said 4.67%. But if you actually applied 4.67% annually compounded, you’d end up with over $15,000, not $14,041. The AAR overstated the growth rate.

CAGR gives the true compounded growth rate. If you apply 3.84% annually to $10,000, you do actually end up at $14,041 after nine years.

For Excel users: the formula is =RRI(nper, pv, fv). For the example above: =RRI(9, 10000, 14041).

Useful Applications of CAGR

CAGR is great for:

• Comparing appreciation rates across two properties you’ve held
• Measuring how rent has grown over time
• Benchmarking a stock portfolio
• Any investment with a clear start value and end value

The book walks through comparing two properties held for twelve years. Property 1: bought at $150,000, now worth $268,000. Property 2: bought at $220,000, now worth $375,000.

• Property 1 CAGR: 4.96% per year
• Property 2 CAGR: 4.54% per year

Property 2 gained more in total dollar terms, but Property 1 appreciated faster on a compounded basis.

The Limitations of CAGR

CAGR can be manipulated by cherry-picking the start and end date. The book gives a sharp example: an investment that went from $50,000, dropped to $25,000, then recovered to $60,000. If you calculate CAGR from the beginning, you get 3.7%. If you calculate only from the trough (when it was $25,000), you get 34%. Both are technically true, but they tell very different stories.

Watch for this when someone is pitching an investment using historical CAGR. Always ask what time period they used.

The other major limitation: CAGR only works when there’s one input and one output. In real life, most real estate investments have money going in and coming out at different times, which brings us to IRR.

Calculating Internal Rate of Return (IRR) - Chapter 22

IRR is the most sophisticated return metric in this section. The technical definition is the discount rate that makes a net present value calculation equal to zero. But what that means practically is: IRR is the annualized compounded return that accounts for the timing and size of every cash flow, in and out.

CAGR falls short when an investment has multiple inflows and outflows. IRR handles all of them.

The book uses J’s first real estate deal as the example. He:

• Bought for $63,500
• Spent $34,000 on renovation
• Had the property sit vacant for six months
• Lease-optioned it for 28 months at $1,000/month
• Pulled $66,000 out in a refinance
• Sold for $120,000 after 35 months, netting $50,000

What is J’s beginning and ending balance? There isn’t a clean answer. The money came and went at different times. CAGR can’t handle this. IRR can.

You list every cash flow with its date, with outflows as negative numbers and inflows as positive. The XIRR function in Excel does the rest.

For J’s deal, the result was an IRR of 16.21% annually.

That’s the compounded annual return that accounts for the fact that spending $34,000 on renovation in months 1 and 2 was less costly to returns than if he’d needed that money on day 1, and that the refinance payout in month 24 boosted returns compared to waiting until sale.

Dave Meyer adds a useful investor story here: he used IRR to navigate Denver’s real estate market in the 2010s. Rather than picking sides in the endless “cash flow vs. appreciation” debate, he just ran IRR on both types of deals and let the math decide. IRR combines everything, including cash flow, appreciation, expenses, and hold period, into one number.

IRR’s Limitations

IRR is powerful but it has real limits.

It’s based on estimates. When you use IRR to project future returns, you’re only as good as your cash flow forecasts. If rent comes in lower, if expenses are higher, if the sale takes longer, your actual IRR will differ from projected.

It ignores deal size. A 15% IRR on a $50,000 single-family rental and a 12% IRR on a $5M apartment building are both valid numbers, but the apartment building generates far more actual dollars. If you need cash flow, a 12% IRR on a bigger deal might serve you better than a 15% IRR on a tiny one.

It assumes reinvestment at the same rate. IRR math assumes you take every cash flow you receive and reinvest it at the same rate as the project itself. If you earn 25% IRR but park your cash distributions in a 0.5% savings account, your real blended return is much lower.

Despite these limitations, IRR is the go-to metric for complex deals: development projects, multifamily syndications, rehab properties, anything with an irregular cash flow schedule. If you plan to invest in those areas, get comfortable with IRR.

Quick Summary

Each metric builds on the last. Use the simplest one that still answers your question well. For quick screening, AAR or CAGR. For complex deals with irregular timing, IRR.

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