What Is Internal Rate Of Return (IRR) And How Is It Used To Make Real Estate Investment Decisions?
Emma Tomsich4-minute read
September 07, 2023
Internal rate of return (IRR) is a metric used to analyze capital budgeting projects and evaluate real estate over time. Investors, business managers and real estate professionals use IRR to evaluate profitability. If you’re interested in investing, learn how to use IRR to make profitable investment decisions.
What Is IRR?
Internal rate of return is a method used to compare the future value of an investment as if it were valued in today’s dollars. You can determine an investment’s risk by calculating its future value, determining its present value in today’s market and comparing it to your initial investment amount.
Investors use a variety of metrics to evaluate risk and decide which investments are worth their time and effort. You can use the internal rate of return to evaluate all types of investments, but for the sake of time, we will use it to evaluate real estate investments.
What Is IRR In Real Estate?
A piece of real estate’s internal rate of return is the projected profit it could earn over the time you own the property. The number is expressed as a percentage you can generate based on each dollar invested.
Next, we’ll explain how to calculate this estimate.
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How To Calculate Internal Rate Of Return
Before we dig in and break down the IRR formula, let’s be clear that no one expects you to calculate these formulas by hand. But seeing them can help clarify what the formula represents and the steps it takes to get there.
It’s also important to note that when an investor calculates IRR, they are estimating the rate of return after accounting for the investment’s projected cash flow with the time value of money.
If an investor has a few investment options to consider, they can calculate the IRR for each investment. Choosing the investment with the highest IRR would likely provide a better return.
IRR is calculated by looking for a discount rate that makes the total value of the investment zero – often referred to as “setting the NPV to zero.” NPV is the net present value of money, and it’s the difference between the present value of cash gains and the present value of cash losses over a period of time. IRR and NPV are both used to determine the profitability of an investment.
IRR gives the investor a baseline to establish how much the current investment will return over a period of time. For example, if the IRR is higher, we can determine that the investment is more likely to be profitable for the investor.
0 = NPV = (Ct ∕ (1 + IRR)t) − C0
- Ct = Net cash inflow during the period t
- C0 = Total initial investment costs
- t = The number of time periods
- IRR = The internal rate of return
You can calculate IRR using these steps:
- Set the NPV to zero (as seen in the formula).
- Solve for the discount rate, which is the IRR.
- Adjust your time periods accordingly to get the average cash flow over time.
Spreadsheet programs like Excel or Google Sheets can perform various calculations, from basic arithmetic to complex financial modeling. Depending on your experience with spreadsheets, you can get very detailed with your calculations and comparisons. Most programs have tutorials to help you get started.
Internal Rate Of Return FAQs
Let’s explore some common questions about IRR and real estate investing.
Why do real estate investors use this metric?
Many investors prefer to calculate the internal rate of return because it includes several long-term factors ROI doesn’t include.
By calculating the IRR for a real estate investment, investors can assess a property’s potential future value by showing what it’s worth today.
Calculating an investment’s IRR isn’t a crystal ball into an investment’s future. IRR calculations rely heavily on projected future cash flows, which can be influenced by unforeseeable external factors.
What are the limits of IRR?
IRR takes into consideration the time value of money but requires additional metrics to get a full picture of a project's costs and returns. For example, if a project has a shorter timeline than another project being considered it may have a much higher IRR.
On the flip side, a project with a longer timeline may have a low IRR but slowly and steadily generates returns. If you’re not evaluating investments with multiple metrics, you may miss out on great opportunities to build your portfolio.
What’s considered a ‘good’ internal rate of return?
Whether an IRR is “good” or “bad” will depend on your goals as an investor.
For example, you may prefer to invest in deals with a 25% IRR or higher, but one day you come across an investment opportunity with a bit more risk at 20% IRR and a shorter development timeline. You may consider pursuing this project because the IRR is high enough and will require less effort – saving you time in the long run.
Generally, a higher IRR is better than a lower IRR when all other contributing factors are the same.
The Bottom Line
When investing, you need to understand how your money works for you. You also need to assess your risk tolerance and determine your time horizon for the return on investment. We recommend speaking with a financial professional to discuss your options if you’re new to investing.
When evaluating your next investment, use all the tools at your disposal to ensure the investment works for you. Take the next step toward a profitable real estate investment and apply for a mortgage today.
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