The IRR “Trap” That Costs Investors Everything | EP. 16

In this episode of The Sage Investor, host Brian Spear breaks down the widespread reliance on internal rate of return (IRR) in passive real estate investing, presenting a core thesis that optimizing for IRR introduces systemic risk and interrupts long-term wealth creation. Spear argues that while sponsors heavily pitch short-term transactions with 20%+ projected IRRs, this practice forces investors into a dangerous game of market timing and constant asset flipping. Using the recent multifamily real estate downturn as a prime example, he explains how rising interest rates exposed the fragility of short-term IRR models, leaving passive investors vulnerable to capital calls, paused distributions, and total capital loss.

To help listeners make better capital allocation decisions, Spear contrasts deal-specific syndications with diversified fund structures, illustrating how funds provide structural alignment of incentives and protect limited partners from a single zero event. He introduces foundational decision-making frameworks for building sustainable wealth, including Warren Buffett’s capital allocation principles from his 1998 shareholder letter, the concept of “assurance of outcome,” and Sam Zell’s “godfather offer” parameter for asset sales. This executive briefing is designed for high-net-worth individuals and passive investors looking to shift their focus away from transactional speed toward durable assets, long-term compounding, and structural risk mitigation. Ultimately, Spear challenges the industry status quo by demonstrating that wealth is measured in time, establishing long-term holding as the default strategy.

Key Takeaways

• IRR measures transaction speed rather than sustainable wealth creation: Chasing high short-term internal rates of return forces investors to continuously exit deals, which triggers heavy tax friction, introduces reinvestment risk, and resets the compounding clock.
• Short-term real estate syndications inherently rely on fragile market timing: Forcing an asset sale within a strict three-to-five-year window exposes capital to macroeconomic shifts, as seen when sudden interest rate spikes disrupted business models reliant on quick exits.
• Fund structures offer superior incentive alignment compared to individual syndications: Investing through a fund pools risk to prevent a total loss of capital from a single underperforming asset, while forcing the general partner to be compensated based on collective performance rather than transactional volume.
• The ultimate factor in capital allocation is betting on the integrity of the manager: A sponsor’s single successful deal does not establish a trend line, making it critical for limited partners to vet the “jockey” as a long-term steward of capital across entire market cycles.
• Asset divestment should be treated as a rare exception rather than a routine default: Disciplined capital allocators should only sell an asset if the core investment thesis breaks, a vastly superior opportunity emerges, or an irrational “godfather offer” is received.

Key Topics Covered

• The structural flaws of the Internal Rate of Return (IRR) metric
• The mechanics of long-term compounding vs. short-term transactions
• Market timing risks and lessons from the recent multifamily real estate downturn
• Tax friction, depreciation recapture, and capital gains implications
• Deal-specific syndications vs. real estate fund structures
• Sponsor incentive structures and general partner alignment
• Warren Buffett’s three core principles for corporate managers
• Risk mitigation strategies and the “assurance of outcome” principle
• Disciplined exit parameters and Sam Zell’s “godfather offer” concept

Episode Chapters

0:00 Intro

Brian Spear introduces the illusion of high projected IRRs and explains how short-term flipping strategies create severe vulnerability to market shifts.

0:51 Everyone Has IRR Wrong

An analysis of why historical investing giants optimize for free cash flow and compounding wealth over decades rather than targeting transactional IRR metrics.

3:49 How Sponsors Got Caught

A review of the 2021 and 2022 macroeconomic shifts, showing how rapid interest rate hikes disrupted short-term syndication models reliant on fixed exit windows.

5:49 3 Dangerous IRR Traps

An in-depth breakdown of the three major pitfalls of IRR-driven strategies: prioritizing velocity over compounding, ignoring heavy tax friction, and navigating sponsor incentive misalignment.

11:44 Bet on the “Jockey”

Why evaluating the operator’s integrity and long-term track record matters more than the specific investment niche or real estate asset class.

15:25 Total Loss of Capital Risk

A mathematical illustration of how repeatedly rolling capital into individual syndications exposes passive investors to reinvestment risks and potential zero-value events.

19:01 What Beats IRR

A guide to the core principles of sage investing, focusing on durable assets, modest double-digit compounding, the assurance of outcome, and strict parameters for selling.

Full Transcript

[Transcript begins]

Brian Spear: Everyone in real estate is chasing the next big thing—a 22% projected IRR, a two-year exit, a quick flip. It sounds impressive, but when you dig deep, you’ll see that the internal rate of return, it often rewards something very dangerous: short-term market timing. And when the market moves against you, those same deals, they can unravel very quickly. And one bad deal can wipe out years of gains. Just look at the multi-family meltdown back in 2021. So today, we’re gonna unpack why IRR-focused sponsors, why they got it all wrong. And we’re gonna talk about what you should look for when building true long-term wealth.

Welcome back to The Sage Investor. I’m Brian Spear and my mission is to help you generate cash flow and build legacy wealth in a tax-efficient manner, because that’s what I’m trying to do for my family. And I’m gonna help as many people as possible along the way. Let’s share all the wisdom that we’re learning along this journey.

As I was building out my real estate business, I noticed a pattern. Every sponsor’s pitch deck was built around one number: IRR, the internal rate of return. Whether it’s an 18% internal rate of return, 22% internal rate of return, even a 30% IRR—I remember a Bitcoin mining fund that had like a 40% IRR—all those sponsors were pitching the same strategy: buy an asset, improve the asset, sell it in three to five years. At first glance, it sounds smart, right? Real estate, it always goes up in the short term, right? But over time, I began to notice something interesting. The investors who ultimately built real wealth, lasting wealth, they weren’t the ones fixing and flipping deals every couple of years. They’re the ones that ultimately own great assets for decades.

If you look at the greatest investors in history—we’re talking about Buffett and Munger and Zell, all the best investors of all time—they were not optimizing for the internal rate of return. They were optimizing for compounding, generating free cash flow, and focusing on compounding wealth. And those are two completely different games, because IRR quietly encourages behavior that interrupts compounding and introduces risk.

Let’s unpack why that’s the case. Like Buffett, my favorite holding period is forever. It’s not a slogan; it’s a design principle in how to allocate capital. Because wealth is built through long-term compounding, not through constant transactions. The moment that you sell an asset, several negative things happen immediately: you pause compounding, you incur taxes, you introduce reinvestment risk, and, you know, you end up resetting the compounding machine. Here’s the issue, right? The metric that dominates the industry, IRR, it often rewards the opposite behavior. IRR is an illusion. It measures the speed of return; it does not measure wealth creation. In fact, IRR can look fantastic on paper, right, even if the investment ultimately produces nominal dollar amounts of returns. It doesn’t create significant wealth, right?

By way of example, right, you invest a hundred thousand dollars. A couple of years later, you sell it to make a hundred and sixty thousand dollars cumulatively in distributions. That’s a fantastic internal rate of return, but now what? Now you pay taxes—depreciation recapture tax, capital gains tax. Your cash, it’s idle. You’ve got a cash drag between when you sell deal A and when you buy deal B. You’ve got to go search for the next deal. You’re incurring a significant amount of reinvestment risk every step of the way. And meanwhile, you know, you’ve made a little bit of money, but the other investor that ultimately, you know, decided to hold a durably wonderful asset for decades, they’re producing dramatically more wealth over time while they’re still receiving significant amounts of durable, predictable cash flow to live life on their own terms. Again, it’s not just the return on investment; it’s also the return on life. While you’re still kind of doing a job of trying to find the next deal, the other individuals are simply receiving cash flow consistently, enjoying life on their own terms, and building wealth in a compounding machine along the way. Compounding favors time, not speed.

But IRR, you know, it doesn’t just interrupt the compounding, it also introduces one of the most dangerous risks in all of investing. Most of the IRR-driven deals assume something very fragile. They assume that the sponsor is going to ultimately be able to sell the asset at the perfect time, exactly at the right time in the marketplace. But real estate markets, they move in cycles. And if your strategy ultimately requires selling in a three-to-five-year horizon, bound by the legal documentation that’s ultimately signed in the operating agreement, you’re essentially making a bet on market timing. And that is an exceedingly dangerous game, because if the market turns before your exit window, the entire strategy can blow up. The investor who owns a great asset for 20 or 30 years, they don’t need to time the market perfectly. They can simply ride out the market cycle. But short-term IRR strategies, they don’t have that luxury.

We saw exactly how dangerous that model can be over recent years. In 2021 and 2022, the Federal Reserve raised interest rates at the highest pace in decades—literally in an entire generation. And financing, it became expensive. And suddenly thousands of deals that were built around short-term IRR exits and decreasing cap rates, they found themselves in trouble. You know, sponsors who planned to sell in year three or four, they suddenly faced a problem. You know, the market had moved against them in a material way. Refinancing wasn’t possible, buyers all disappeared, and many of the operators, they were forced to either sell at a loss or inject new capital. In some cases, they ended up having to, you know, lose the property entirely. Investors that were hurt the most during this period of time ultimately were the ones that were riding high, using significant amounts of leverage along the way, and they were, you know, implementing that short-term IRR strategy. Because their model ultimately required a perfect exit window, and when that window closed, the strategy ended up breaking.

And that leads to the three traps that IRR-focused sponsors fall into. The first trap is velocity over compounding. IRR rewards speed, but wealth rewards patience. And every single sale that you have along the way, it resets the compounding clock and it forces investors to take on incremental new risk with each individual deal, continuing to increase over time.

The second trap that folks face when trying to implement that IRR model is they’re ignoring tax friction. IRR assumes a frictionless world in a spreadsheet. It looks really good, but investors don’t live in a spreadsheet. They live in a world where you receive taxes. Every single sale includes capital gains taxes, depreciation recapture taxes, transaction costs—you’re gonna have to pay broker fees and defeasance and yield maintenance and a little bit of other things. But the sage principle that we will continue to refer back to over and over and over again is defer, defer, delete. Defer taxes as long as possible.

You know, and that brings us to the third trap, which is sponsor incentive misalignment. Sponsors often get paid through transactions. They get acquisition fees, disposition fees, asset management fees, capital transaction fees. You know, they often get paid by doing deals. But investors, they build wealth through long-term ownership of assets, by holding properties over exceedingly long periods of time. And those incentives, they’re not always aligned.

Let me expand on this and just give you an example from my perspective, kind of directly for folks investing passively in real estate syndications. Oftentimes folks have the opportunity to either invest in deal-specific syndications or fund structures. I would take the position that a fund structure is superior. I’m obviously biased, take it with a grain of salt. I can go on and on and on about sharing the merits associated with that. I do genuinely believe it affords you better deals in the marketplace. If you’re going to a broker and you’ve got tens of millions of dollars on the balance sheet, it’s a lot easier to get the best deals in the marketplace than stating with a deal-specific syndication, “Trust me, I’m gonna go raise XYZ dollars from partners once I get this deal under contract.” For this reason, you’re going to get better deals.

But the most important thing is not just the deals and the optionality that it provides the general partner. The most important thing is the incentive structure between the limited partners and the general partners. So let me give you an example. Let’s say you’re going to go do 10 different individual deals, okay? In both scenarios, ten of them are going to be individual deal-specific syndications versus 10 deals inside of a fund structure. Let’s run what this looks like. Both of the different structures have the same exact deals with the same exact individual returns. In the deal-specific syndication, let’s take the hypothetical example that nine of those deals perform the way that you would have otherwise anticipated. You get some singles, some doubles, some triples; you might even get a couple of home runs along the way. Congratulations. But on the 10th deal, that deal goes poorly. It goes so poorly that the investors end up losing all their money. They have a single zero event. The investors lose all their money in that respective scenario. Let’s work through kind of how do the limited partners do? Well, the majority of the limited partners, they’re actually feeling pretty reasonably well. They, again, single, double, triple, did pretty well. The investors in the 10th deal, unfortunately, were in a very precarious situation. How does the general partner feel about the situation? Well, the general partner, they actually feel pretty solid. Why? Because they made millions and millions and millions of dollars on the first nine deals. And in the 10th deal, well, the investors—the limited partners—ended up losing all their money, but the general partner feels pretty good. It was more of a “heads I win, tails you lose” scenario from the general partner’s perspective.

Now let’s look at the inverse scenario where those same exact deals are inside of a fund structure. Let’s assume that nine of those deals are doing well—single, double, triple, a couple of home runs, whatever the case may be—but one deal goes to zero. In that scenario, what occurs? Now, granted, the investors give up the grand slam or the home run. They don’t get those massive returns. But also on the flip side, the investors on the back end, they don’t lose all their money. They avoid the single zero event. And what happens is the return kind of reverts closer to the mean. And maybe those returns aren’t massive grand slams, but they end up kind of reverting. They likely get all their money back, maybe they make a very phenomenal return along the way. But again, no single zero event. They just do okay along the way. Now, what does the general partner do? What is the GP, how does he feel about it? Well, the general partner, he probably didn’t make anything. He probably worked for five, six, seven years and made zero dollars on the investment. From my perspective, that is a significantly better alignment of interest along the way.

General partners should be incentivized by performance, not by taking incremental risk. And what this structure ends up setting up, if you’re going to do deal-specific syndications versus the fund structure, it heavily incentivizes the sponsor in the individual deal-specific scenario to take inordinate and massive amounts of risk to try to drive the highest internal rate of return. But in doing so, you’re introducing significantly more risk into each individual investment. Why? Because obviously, the higher the internal rate of return, when you get into the promote structure, the general partner receives more of that downstream. So they’re incentivized to do so. However, the general partner inside of a fund structure does not end up benefiting in a material way by taking that significant incremental risk. Why? Because they are more likely to lose their entire promote by taking that level of risk, because they’re introducing too much risk and ultimately could adversely affect the entirety of the outcome of the fund. And it is for this reason that that perverse incentive drives the behavior that it does from general partners and limited partners. And what you really are trying to ultimately ensure when you’re investing with a sponsor is that you have the purest alignment of interest that you possibly can along the way.

At the end of the day, the individuals that have been doing this the longest, they will always understand and refer back to our sage principle of bet on the jockey. They understand it’s not about the individual deal. It’s not even about the individual niche. It is about the human being that is ultimately managing capital. From my perspective, that is far superior than the niche in which you invest or the individual deal in which you invest—the human being managing the capital and how they’re choosing to manage the capital reigns supreme. That is the number one aspect.

It’s kind of like Brian Tracy back in the day would talk about core values. And you know, these businesses would have these various different core values, and you’d have five, six, seven of them. You know, you had to be determined, you got to have drive, you want to continue to learn along the way. And then they have a core value that would be plopped up that would say integrity. Brian Tracy would make the contention that, which of these individual core values are the most important? And integrity was always the number one because integrity was the core value that insured all of the other core values regardless. You know, if the individual is determined and focused and XYZ, all the various myriad of things, if they did not have actual integrity, all the rest of it was completely irrelevant. And it’s why betting on the jockey is the most important and profound aspect that LPs should be focusing on when determining where to place capital, with whom to place capital.

I believe the best possible way that I’ve seen a capital allocator share with the business owner who’s ultimately making the decisions for the business—the best way to ultimately manage that business and manage that respective capital—the most prudent advice that I’ve ever seen provided is from Warren Buffett in his 1998 shareholder letter over at Berkshire Hathaway. Whenever he buys a business—you know, Berkshire Hathaway’s got tens of thousands of employees across the country—but at the corporate office, they only have about 20 different people in Omaha, Nebraska. So when they’re allocating capital, they’re betting on the jockey. They’re betting on the owner, the CEO of Geico. They’re betting on the owner, the CEO of See’s Candies, and they’re allowing them to run the business and they’re getting out of the way. They’re trying to hire Mark McGwire and not teach Mark McGwire how to swing the bat. But they’re, as a prudent capital allocator, finding the right business to invest in and letting them do their job.

And he says, “Look, I’m not going to get in your way. I’m not going to tell you to run your business right. You know more about it than I do, boots on the ground. That’s why I’m allocating capital with you. However, I’m only going to ask you these three things. For any manager that I have in the business, I ask them three things.” I just want you to run the business as if—and I literally have this printed, the 1998 chairman letter printed on my desk—just run the business as if: one, you own 100% of it; two, it is the only asset in the world that you and your family have or ever will have; and three, you can’t sell it or merge it for at least a hundred years.

Because I can promise you, referring back to the deal-specific syndication and the fund structure, if that deal-specific syndicator was acting in the manner that Warren Buffett has stated, and they were acting as if they own the business, the only business that they own, and it’s a hundred percent of their respective capital, they would not be taking the inordinate amount of incremental risk on those individual deal-specific syndications. They would be operating it in a more prudent fund structure trying to drive the best risk-adjusted returns for their family. And this is why, from my perspective, a fund structure is far superior than an individual deal-specific syndication. And it all simply refers back to sponsor incentive misalignment. You’ve got to ensure that you’re betting on the jockey and not the horse along the way.

So let’s go back to the individual deal-specific syndications and we’ll introduce the concept of time, okay? Let’s say that you were the single individual that was investing in the first deal, then the second deal, then the third deal, etc., all the way through deal number 10. This is often the case when a general partner and a limited partner are working together in individual deal-specific syndications. Let’s say somebody invests a hundred thousand dollars into that respective transaction in deal number one. The deal goes well. Let’s say they double the money in five years, whatever the case may be, and now you’ve got two hundred thousand dollars. Well, oftentimes the limited partner thinks, “This individual is obviously wonderful. He’s an exceptional investor, he’s done a great job on this one individual transaction. I want to try to double down, keep the chips on the table, make sure that we try to double again, right?” Invariably, the general partner will find another deal because they get paid by doing deals. And so another deal presents itself, and let’s say that the second deal, oh my gosh, it goes well in the same vein. The capital moves from two hundred thousand dollars to four hundred thousand dollars over time. Congratulations. This individual is so wonderful. Oftentimes, you know, friends and family are brought involved along the way. And let’s let’s all pile in now that we’ve, you know, proven track record over the course of three, four, five different transactions.

And then eventually market timing occurs where—I don’t care if you’ve gone from a hundred thousand to two hundred thousand, two hundred thousand to four hundred thousand, four hundred thousand to eight hundred thousand—at some point, somebody somewhere is going to mis-time the market. They’re going to run into a deal that introduces incremental amounts of risk along the way, reinvestment risk. And that entire amount, no matter how large that amount goes, in one fell swoop, any number, no matter how large, multiplied by zero is zero. And that’s why there’s so much more risk associated with investing in individual deal-specific syndications compared to a fund structure. When you introduce that additional market timing risk where you’re doing the fix-and-flip model, invariably in a deal-specific style, that is going to occur over and over and over. And if you’re willing to accept the market timing risk over and over and over and over and over, eventually you will mis-time the market. It is an inevitability. You do not know when that is going to occur. Everyone’s crystal ball is broken, my crystal ball is broken, and yours is too. But it is an inevitability that you will mis-time the market, and investors will end up with paused distributions, capital calls, and sometimes total loss of capital by implementing that more risky business model.

From my personal perspective, the lesson here is simple: one data point does not a trend line make. So if you’re focused on one individual data point, one individual metric in an investment such as IRR, that does not provide the holistic perspective that is necessary to prudently allocate capital. Nor does one data point a trend line make in regards to the track record of a given individual sponsor. Just because one deal went well doesn’t mean that that is an exceptional allocator of capital. The truth is somebody has to prove their merits over multiple cycles, exceedingly long periods of time, in my humble opinion, to be trusted as a prudent steward of capital. Starting small and then growing over time, using your own capital to prove the track record along the way, and then incrementally bringing on friends and family, and then eventually, after you’ve proven your track record and craft over a decade, being willing to explore bringing on some additional partners to come along for the ride with you. But just because somebody did a deal one time well and the rate of return was solid, one data point does not a trend line make. Much more needs to be put into that analysis to ensure that that jockey, as it were, is actually an exceptional steward of capital, a great investor, as opposed to a lucky idiot. And that’s the truth.

So if you’re not going to focus individually on IRR, if you’re not going to focus on that one individual data point of IRR, what should you be focused on, right? Disciplined investors, sage investors, they focus on a handful of things.

The first is durable assets—assets that can be owned for decades. Durably wonderful businesses, supply-constrained, essential-use real estate, recession-resistant, durably wonderful businesses that have been throwing off cash flow for decades, that are throwing off cash flow today, that are going to throw off cash flow for decades to come. And wonderful in that they’re likely to increase in value over long periods of time. Durable assets, focus on that.

Secondarily, you’re going to focus on long-term compounding. You want an asset that’s producing, as an example, an 8% yield on an annual basis and 4% growth. That’s 12% compounding. You’re focusing on quality, risk-adjusted returns that can compound over exceedingly long periods of time. And what we’re trying to achieve is modest double-digit compounding returns with exceedingly de minimis risk over decades. That math becomes extraordinary. One of the pillars that we have of the capitalist strategy is assurance of outcome. In a perfect world, I’d be betting on a sure thing. Of course, there’s no guarantees in life, but we’re minimizing risk to the best of our ability in every step of the way. I’m unwilling to bet my family’s financial future on something that I don’t perceive to have an exceedingly high assurance of outcome. And along the way, if we can do so by taking a very de minimis amount of risk and generate quality double-digit compound returns over time, I feel very good about that scenario.

And the third piece of the puzzle is selling only when the signal is actually real. You know, selling should be rare. It should not be a routine piece. The default should be to hold assets. And the valid reasons why you might sell would include: you’ve got a broken investment thesis, something materially has changed; or you’ve got a vastly better opportunity in the marketplace that can generate significantly higher compound interest than that what you are currently generating; or third, what Sam Zell fondly refers to as a godfather offer—a price that is so irrational, somebody’s wanting to pay you some sort of absurd number that you have to take it. But if you sell simply because the pro forma said, “This is a five-year hold or a three-year exit,” and we need to sell after we hit this internal rate of return or this number, that’s not discipline. That is a habit that introduces exorbitant amounts of risk over the long term to a capital allocator’s strategy.

Most investors, they think that the goal is to find the next deal. But the real goal is to find an asset that is so good that you never have to find the next deal, that you never have to sell it. When I’m 85 years old and I’m looking back at the end of the rainbow, right, I doubt that I’m going to regret having held durably wonderful businesses for decades, having held too long. But I know that invariably I will regret those deals that I have sold, where I have interrupted decades of compounding just to chase a headline internal rate of return. Because IRR, it measures speed. It measures speed. But wealth, it measures time. Hold is the strategy, selling is the exception, and forever is the default.

All right, guys, with that we’ll get out of here. We’ll see you on the next one. Until next time, keep it right.

[Transcript ends]