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internal rate of return with calculator
admin February 21, 2020 0 Comments

Internal Rate of Return (IRR) vs Cost of Funds

Published by Jacob McCoy

internal rate of return with calculator

eQcho Capital knows we come as a huge advantage to the cannabis industry due to the majority of eQcho Capital employees coming from banking. Also, our focus is cannabis, hemp and CBD only. eQcho Capital is determined to be the number one small business lender for the cannabis industry.

For more information, send an email to info@eqcho.com

Judging a Loan by the Numbers

The cannabis industry in the US is at a stage where FDIC insured banks just aren’t willing to lend in the space. If you’ve had any experience in the industry, you likely know that loan rates in the industry just can’t compete with traditional bank rates. This is due to:

  1. Cannabis being federally illegal
  2. The risk of the bank losing FDIC insurance
  3. Cannabis industry participants only have a choice between giving up equity in their company, and debt financing

Now, while rates in the industry may be higher than traditional bank loan rates, this does not mean you should not take on debt because the rate is 15%, or whatever it may be. You can not judge how expensive the financing is based on the number alone, you have to compare it to something. That something is what is called your Internal Rate of Return (“IRR”).

LET ME PREFACE BY DEFINING AND EXPLAINING A COUPLE TERMS.

  1. Internal Rate of Return (“IRR”) – IRR is the minimum rate of return at which the Net Present Value of a project is $0. If the IRR of a project is greater than the cost of funds, then you should take the loan and run. There a couple other assumptions IRR makes, but for simplicity’s sake, we’ll leave those out.
  2. Net Present Value (“NPV”) – The amount of wealth created by a project discounted at the cost of funds. The golden rule is that If NPV is greater than $0, then take the loan.

I hope now that you understand that you can’t just scoff at an interest rate; you have to do a little bit of digging to truly find out if the quoted interest rate is “expensive.”

How do you calculate your IRR? Well, there’s an easy way and a hard way. The easy way is to pull up Excel, Google Sheets or even a financial calculator if you have one of those hanging around. I know for a fact there a multitude of financial calculator apps you can download to your phone.

From here on out, a real estate transaction purchase will be used as an example. Let’s also assume the property has a tenant who operates in the cannabis space. In that case, no FDIC insured bank will touch the property. So, private funding is required.

AN IRR CALCULATION CONSISTS OF 3 COMPONENTS:

  1. The initial outlay of your cash, i.e. the cost to acquire real estate, or perhaps perform tenant improvements.
  2. The subsequent cash flows received at separate time intervals. In terms of real estate, this would be the rent received from the tenant.
  3. The last cash flow, which can either be:
    1. The sale of the property, or,
    2. The perpetual cash flow from the property

Let’s assume the following:

  1. Purchase price of $1,000,000
  2. Loan to Value of 60%, i.e. a loan amount of $600,000
  3. Cash required from you, to close the deal: $400,000 ($1,000,000 – $600,000)
  4. Annual Net Operating Income (NOI) of $120,000
    1. This is a cap rate of 12%, which is average for the cannabis industry
  5. You plan to hold the property in perpetuity
  6. You form a new lease that escalates rents 5% each year (your compensation for the risk associated with cannabis’ legal status)
  7. The loan’s interest rate is 15% (seems high, right!) and consists of interest-only payments

The IRR calculation will look like this:

Let me explain. The left panel has your initial cash outlay as only $400k, as that is your out-of-pocket cash. The other $600k came from the loan. This is called leveraging and is what ultimately leads to higher IRR’s because of the risk associated with leverage. The right panel is the same transaction, but you did not take out a loan and bought the property with cash. As you can see, utilizing the loan leads to a much better IRR.

Now, if we go back to the definitive rule, you should accept any project where your IRR > cost of funds. In this case, your IRR is 45% and the cost of funds is 15%. The 15% seemed high and is high compared against normal bank rates, but, since 45% > 15%, the 15% is a steal.

It’s a matter of putting context to the cost of funds. If you hear the interest rate is “15%,” don’t assume it doesn’t make sense to take the loan. Calculate your IRR first!