Education, Finance

Understanding IRR – What You Need to Know

smartland-understanding-irr-what-you-need-to-know.mp3 Let’s break down the IRR formula to know about this financial analysis metric before applying it to your own investment comparisons... Listen to this article

Whether you’re just beginning your real estate investing journey, or you may 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 various formulas and compare metrics of similar properties to answer questions such as cash flow, net income, price and more. However, they can also use internal rate of return IRR.

Today, let’s break down the IRR explained 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 real estate investment metrics like the net present value or NPV. However, it’s also a distinct calculation that may be a very valuable tool as you build your portfolio from scratch.

Understanding IRR – What You Need to Know

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 of an investment it is. Because of its versatility, the internal rate of return 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 understand IRR, you need to know net present value (NPV), which is the difference between the present value of cash gains and losses over a period of time. Positive NPV is better as it indicates a gain, rather than a loss.

Time Value Of Money “TVM”

Inherent in both of these metrics is the TVM or time value of money. The time value of money is a broad idea that money now is worth more than its exact sum due to its potential future cash flows or profits. (provided you use it wisely, of course).

Under the TVM principle, money is worth more if received sooner as it earns interest or can produce other profits. TVM is also known as “present discount value”.

Related: Multifamily Real Estate Investing for Beginners

Why is IRR Useful for Investors?

Investors use IRR to compare the interim cash flows of two different properties or investment potentials with different timing. It’s useful for capital budgeting as it allows projection of future earnings 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, it can also 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 internal rate of returns 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 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, 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 internal rate of return 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 for example, if you purchase a property for $1 million, rent it out for $125,000 per year over 4 years, and plan to sell it for $1.5 million in 5 years, you would have 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 consistent income until selling the property for a profit. By setting NPV to zero, you can determine the IRR. By year four, cash flow increases as the profits from the sale are added to 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 formula is a bit math-heavy, using an IRR financial calculator or Microsoft Excel is recommended. Excel also offers formulas for manual calculation of IRR.

As a bonus, using computer programs reduces the chance of math errors and incorrect IRR calculations, which can help avoid inappropriate investment decisions.

Downsides to the IRR Formula

Even though IRR calculations can be beneficial, there are some downsides to this metric. The internal rate of return 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 much 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% internal rate of return), 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.

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.

Are you interested in learning more about Smartland’s investment strategy? Contact us today.


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