Internal Rate of Return (IRR): What It Actually Tells You in a Net Lease Deal

What it is

Internal rate of return is a single number that tries to capture the whole story of a deal — every dollar you put in, every dollar you get back, and when each of those dollars moved — and boil it down to one annualized percentage.

Here's how I explain it across the table: cap rate tells you what a property earns in year one. IRR tells you what your money earned over the entire time you owned it, including the day you sold. It accounts for the rent checks along the way, any bump in value when you sell, and the timing of all of it. A dollar you get back next year is worth more to your return than a dollar you get back in year eight, and IRR is built to reflect that.

It's a projection, not a guarantee. Every IRR number on a pro forma is only as good as the assumptions feeding it — your hold period, your exit cap rate, your rent growth. Change any one of those and the number moves.

How it plays out in retail net lease

Net lease is a cash-flow business first and an appreciation business second, so IRR tends to matter more here than it does in, say, a value-add multifamily deal.

On a long-term single-tenant deal — a drugstore, a QSR, a bank branch — most of your IRR is coming from the rent stream, not from betting the property is worth more later. The lease is doing the heavy lifting. That's the whole appeal of net lease: the return is more predictable because it's contractual.

On shorter-term deals or ones with upcoming lease rollover, more of the IRR depends on what happens at renewal or re-tenanting, and on where cap rates sit when you eventually sell. That's where two deals with the same cap rate today can carry very different IRRs once you model the whole hold.

I've sat across from buyers comparing a 6% cap rate deal against a 6.5% cap rate deal and picking the higher cap rate every time, without ever asking what the lease does in year six. That's the gap IRR is meant to close — it forces you to look past the entry number.

What to watch for

• The exit assumption is doing more work than people realize. A small change in the assumed cap rate at sale can swing the IRR more than years of rent growth. Ask what exit cap rate is baked in and whether it's realistic.
• Rent bumps look great on paper. Contractual increases drive IRR, but only if the tenant is still paying rent when they hit. Check the tenant's staying power, not just the lease terms.
• Longer holds compress the impact of a bad exit. A short hold puts almost all your return riding on one sale event. A long hold gives operating income more time to carry the number.
• IRR can be flattered by early cash flow and hide a weak back half. Look at the year-by-year breakdown, not just the final percentage.
• Two deals can show the same IRR with completely different risk. A steady net lease credit tenant and a speculative redevelopment play can land on the same number through very different paths.

How to use it to your advantage

Don't treat IRR as a pass/fail line. Treat it as a way to compare deals against each other and against what you're already holding.

I ask clients to build two versions of the projection — one with conservative assumptions, one with the seller's or broker's assumptions — and look at the spread. If the IRR only looks good under optimistic numbers, that tells you something.

Also ask what's driving the number. A high IRR built mostly on rent collected from a strong tenant is a different animal than a high IRR built mostly on hoping cap rates compress by the time you sell. I'll take the first one most days.

Best case, worst case

Best case

• Tenant performs, rent bumps hit on schedule, and you exit into a stable or improving cap rate environment
• Actual cash flow tracks or beats the pro forma
• IRR realized is close to, or above, what was projected at purchase

Worst case

• Tenant vacates or a renewal falls through and downtime eats into cash flow
• Cap rates move against you at sale, compressing your exit value
• A projection that looked attractive on paper turns into a return well below what was modeled — or a loss

This is general education, not investment, tax, or legal advice — verify all figures and assumptions independently before making any decision.