Categories: Education

Understanding IRR – What You Need to Know

Introduction

Whether you’re just beginning your real estate investing journey or already have some experience, you’ll eventually need to decide between two different investment possibilities. Should you choose one property or the other? Which property will be a better return on your investment in the long term?

To answer these questions, investors can use a variety of mathematical formulas and compare the metrics of similar properties. You might look at cash flowQuestion Mark, net incomeQuestion Mark, price, and more. But you can also use the IRR or internal rate of return.

Today, let’s break down the IRR and explore what you need to know about this useful financial analysis metric before applying it to your own investment comparisons.

What is IRR?

IRR or the “internal rate of return” is a financial analysis metric that investors can use to determine how profitable a potential investment might be. It’s closely related to other metrics like the net present value or NPV, but it’s also a distinct calculation that may be a very valuable tool as you build your portfolioQuestion Mark from scratch.

In general, the internal rate of return describes the discount rate at which the NPV of a set of cash flows equals zero. Put another way, the IRR is how quickly a real estate investment grows or shrinks. You can think of the IRR as the compounded annual rate of return.

IRR or the “internal rate of return” is a financial analysis metric
that investors can use to determine
how profitable a potential investment might be.

In most cases, the higher the IRR for a given property, the more desirable an investment it is. Because of its versatility, the IRR can be used for different investments of varying types, like multifamily or single-family properties, commercial real estate properties, and more. When you compare multiple properties’ IRR ratings, the property with the higher IRR will probably be your best bet for success.

Other Metrics Investors May Use

To fully grasp IRR, you need to understand NPV or net present value of money. The NPV is the difference between your present value of cash gains and the present value of any cash losses over a set period of time. Positive NPV is better as it indicates you’re gaining money instead of losing it.

Inherent in both of these metrics is the TVM or time value of money. The time value of money is a broad concept that the money you have now is technically worth more than its exact sum because it may produce future cash flows or profits later down the road (provided you use it wisely, of course).

Under the TVM principle, money is worth more if you receive it sooner since it earns interest or can be used for other profits as time goes on. TVM is also sometimes understood as “present discounted value”.

Related: Multifamily Real Estate Investing for Beginners

Why is IRR Useful for Investors?

Investors use the IRR because it allows you to compare the interim cash flows of two different properties or investment potentials with different distributions for timing. It’s a great tool for capital budgeting since you can then project when you might earn in the future, or cash outflow.

Investors use the IRR because it allows you
to compare the interim cash flows of two different properties
or investment potentials with different distributions for timing.

Furthermore, IRR can help an investor understand the yearly earnings they received from a specific property. In other cases, IRR can help investors understand how much they will earn from a property over time as their investment pans out (or, in the worst-case scenario, falls short of expectations).

The IRR Formula Explained

Let’s break down the IRR formula in detail. To get that formula, you need to know how to determine NPV with the below formula:

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

In this formula, the letters mean:

  • i = the required return or discount rate
  • t = The number of time periods

Next, you can calculate IRR by setting your NPV to zero. Remember, IRR is the discount rate for an NPV in which the potential investment cash flow is zero. The formula is as follows

NPV = (nΣt=0) X (CFt/(1+r)t)

For this part of the formula, the figures 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

Unfortunately, IRR is complex enough that it’s 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.

IRR is how quickly a real estate investment grows or shrinks. You can think of the IRR as the compounded annual rate of return.

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:

Year 0 (when
you purchased
the property)
Year 1Year 2Year 3Year 4
-$1,000,000
since you
purchased the
property for
$1 million
$125,000$125,000$125,000$1,625,000

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 profitQuestion Mark. 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 valueQuestion Mark 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.

The IRR can tell you what the cash return for an investment opportunity might be, but there is still some guesswork involved.

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.


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