Introduction

Whether you're just starting out in real estate or you're a well-seasoned investor, there will come a time when you will have to decide between two different investment possibilities. It comes down to a classic scenario of “this or that” and you will need to choose which option will be better in its long-term return on investment.

As investors, we rely on multiple mathematical formulas to compare and contrast the different metrics of the deals in order to make an educated decision. You may look at cash flow, net operating income, price, and capitalization rates but you can also use the IRR or Internal Rate of Return.

What is IRR?

IRR or the "internal rate of return" is a metric used to calculate the profitability of an investment over a period of time. IRR is expressed as a percentage and it is determined by finding the rate of return that makes the net present value of all cash flows from the investment equal to zero. To put it another way, the IRR is how quickly a real estate investment expands or contracts. Think of the IRR as the compounded annual rate of return.

In the majority of cases, the higher the IRR for a property, the more lucrative an investment. Because of its versatility, the IRR can be utilized for different real estate investment types whether you're flipping houses, developing multifamily properties, or simply buying and holding rental units.

IRR is just one of the many metrics you can use in your analysis, but it's an important one that should not be overlooked. When you're comparing and contrasting your investment options, the property with the higher IRR will most likely be the most successful investment.

Other Metrics Investors May Use

To fully comprehend IRR, you'll need to understand NPV or net present value of money. NPV is the difference your present value of cash gains and losses over a set timeframe. We all know that positive numbers are better, right? And the NPV of a financial statement is one way to see if you’re gaining or losing money.

Intrinsic to both of these metrics is TVM or time value money. The general notion of the time value of money means that your cash is technically worth more now than its exact sum because it might produce future profits or additional cash flow later on... (If you're investing it wisely).

Inside the TVM principle, the sooner you receive money, the more valuable it becomes since that same cash can earn interest or be used for other profits as time goes on. TVM is similarly recognized as "present discounted value".

Why IRR is practical for Investors

Investors use IRR because it allows you to compare the interim cash flows of two differentiating deals or investment potentials with varying distribution schedules for timing. In my opinion, it is the absolute best tool for budgeting your capital allocations since you can predict when your future earnings will appreciate and when you can expect cash outflow from each particular investment.

Additionally, IRR is a wonderful tool for investors who want to understand the yearly earnings of their properties. Or in the worst-case scenario: where the deal falls short of assumed expectations.

IRR Formula Explained

Let's take a detailed look at the IRR formula. First you'll need to know how to determine NPV with this formula:

NPV = Cash flow / (1+i)t - initial investment

The letters in the formula mean:

• i = the required return or discount rate

• t = the number of time periods

Next, Calculate your IRR by setting your NPZ at zero. Don't forget that IRR is the discount rate for an NPV in which the potential investment cash flow is zero. This is the formula:

NPV = (n∑t=0) X (CFt/(1+r)t)

The letters in this formula mean:

• Ct = Net cash inflow during the time period t

• C0 = Total initial investment costs

• t = The number of time periods

• IRR = The internal rate of return

Alas, IRR is indeed complex and very difficult to calculate analytically or by hand. Instead, you’ll usually calculate the IRR by gathering data through programs like Microsoft Excel and its XIRR Function or by plugging that data into software designed to calculate IRR. Indeed, IRR calculators are the best way to determine the IRR for a potential investment due to their simplicity and ease of use.

IRR Examples

Let’s break down an example of IRR so you can see how this formula works in action instead of getting bogged down with math. Say that you purchase a property for $1 million. You rent it out to a tenant who pays $125,000 per year over four years. Additionally, you plan to sell your property and five years for an asking price of $1.5 million. As a result, you would have periodic cash flow in the following payback periods:

In this and similar IRR examples, you assume that you’ll make consistent income each year until you plan to sell the property for a profit. Set NPV to zero and you can determine the IRR for this property. By year four, you’ll have increased your cash flow since the profits from the sale are added to your rental income.

NPV = -1,000,000 + 125,000/(1+ IRR)1 +125,000/(1+ IRR)2 + 125,000/(1+ IRR)3 + 125,000/(1+ IRR)4 = 0

When you have all the math together, you get an internal rate of return of 21.61%. That’s a pretty good return on your investment by all measures!

Again, the IRR formula is a bit math-heavy, so it’s usually a good idea to plug your data into an IRR financial calculator or even just use Microsoft Excel. That program has formulas that investors can use to calculate the IRR by hand if they so choose.

As a bonus, using computer programs lowers the likelihood that you’ll make a math mistake and end up calculating an incorrect IRR, which may then cause you to make an inappropriate investment decision.

Downsides to the IRR Formula

Even though IRR calculations can be beneficial, there are some downsides to this metric. The IRR can tell you what the cash return for an investment opportunity might be, but there is still some guesswork involved. This metric is limited and it is only really accurate if you compare several similar investments over the same length of time.

If you need to compare the potential return on different investments over different lengths of time, IRR is much less useful.

Additionally, IRR has the following downsides:

• You have to guess about the potential sale price you’ll get

• You have to guess about how long you’ll own the property

• The IRR doesn’t account for any repairs or other costs that may affect your investment (and realistically, several will)

• The IRR doesn’t account for not having a tenant in your property furnishing you with rental income for a month or a longer span of time

• IRR depends on you knowing your cash flow or income. If it isn’t stable, IRR is must less useful

• IRR never tells you the total return on an investment, so it may not be good for determining whether you should consider reinvestment in an investment project

Therefore, it’s a good idea to only use IRR in conjunction with other analysis metrics when determining whether a property is a good investment or not. It’s not a one-size-fits-all solution and can’t be used in isolation.

Is a Higher IRR Always Ideal?

While it’s true that a higher IRR is usually better than a lower IRR (for example, a 15% internal rate of return is hypothetically better than a 10% IRR), a project’s IRR can also be misleading if you use this formula by itself.

For instance, if you make several incorrect assumptions about a property – such as just assuming you’ll be able to sell it at a specific time for the price you demand – your highest IRR or projected future value might be more than it actually will turn out to be in real life.

Additionally, if you are analyzing a property using financial information provided by the current owner and your IRR seems higher than it should be, this could be a sign that the owner is cooking the books or presenting inaccurate information.

Again, you should only ever use the IRR in conjunction with other financial analysis methods and formulas.

Summary

Ultimately, understanding IRR is crucial if you want to use this analysis formula when comparing properties and their potential investment returns. That said, be sure to use IRR correctly and sparingly, and only ever when you feel confident that you know the rent or expected net cash inflow from a property over a given timeframe.