What Is Internal Rate Of Return (IRR) And How Is It Used To Make Real Estate Investment Decisions?
Emma Tomsich4-minute read
June 21, 2022
Internal rate of return, or IRR, is a metric used to analyze capital budgeting projects and evaluate real estate over time. IRR is used by investors, business managers and real estate professionals to evaluate profitability. If you’re interested in investing, read on to learn how others invest intelligently.
What Is IRR?
Internal rate of return is a way of comparing the future value of an investment as if it were valued in today’s dollar. By calculating what an investment will be worth in the future, what its value would be in the market today, and comparing it to the amount of your investment, you can then determine an investment’s risk.
Investors use a variety of metrics to evaluate risk and decide which investments are worth their time and effort. Internal rate of return can be used to evaluate all types of investments, but for the sake of time, we’re going to use it to evaluate real estate investments here.
How Do I Calculate IRR?
Before we dig in and break down the IRR formula, it’s important to know that no one expects you to calculate these formulas by hand. But it clarifies what the formula represents and the steps it takes to get there.
Manually Calculate The NPV And IRR
To manually calculate the internal rate of return, you need to determine the NPV or net present value. This is the formula to calculate NPV:
i=Required return or discount rate
t=Number of time periods
Calculate IRR by setting NPV to 0
IRR is calculated by setting NPV to 0. IRR is the discount rate for which the net present value of an investment is 0.
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
Use A Financial Calculator
As we said before, there are financial calculators that allow you to enter the important details and your final IRR is calculated in seconds. A simple Google search for financial calculators will give you a variety of options and levels of detail.
Most spreadsheet programs like Excel or Sheets can calculate basic and advanced financial calculations. If you have some experience with spreadsheets, you can get very detailed in your calculations and comparisons. Most programs have tutorials that can help you get started.
IRR Vs ROI
Some may assume ROI and IRR are interchangeable. While they’re similar, they have different outcomes.
Return on investment, or ROI, is calculated by taking the difference between the current or expected value and the original value divided by the original value, multiplied by 100.
ROI calculates the total growth of investment from start to finish. IRR calculates the investment’s annual growth rate. This means that ROI reflects what has already occurred, while IRR is a projection of what will happen. ROI doesn’t take into consideration the time value of money or TVM, but IRR does.
ROI is more widely used than IRR because it’s easier to calculate. While these two calculations may seem similar over the course of one year, they will not be the same when compared over longer periods of time.
FAQ: Other Questions Regarding IRR
Why do real estate investors use this metric?
Many investors prefer to calculate the internal rate of return because it includes several factors ROI does not. When calculating IRR for an investment, an investor is estimating the rate of return after accounting for its projected cash flow and with the time value of money.
If an investor has a few options to consider when investing, they can calculate each opportunity’s IRR. Choosing the investment with the highest IRR would likely provide a better return.
As previously mentioned, IRR is one metric an investor can use to determine if an investment is worthwhile. This metric is closely related to the idea of the net present value of money, or NPV. Similar to IRR, NPV is the difference between the present value of cash gains and the present value of cash losses over a period of time. IRR and NPV have comparable uses and yield the same goal of determining profitability.
Ultimately, calculating the IRR for each prospective real estate investment will help investors understand what it will be worth in the future by showing what it’s worth today.
We have to mention that calculating an investment’s IRR isn’t a crystal ball into the investment’s future. IRR calculations rely heavily on projected future cash flows which can be influenced by a lot of unpredictable outside factors.
What are the limits of IRR?
The internal rate of return is a great metric for estimating an investment’s potential. It’s often used to analyze capital projects and improvements and how they affect the overall costs.
IRR can predict positive cash flows and account for bigger-ticket expense items, but it is limited to projections and estimates. IRR is easily misinterpreted and can be used to mislead potential investors or shareholders. IRR and NPV are estimates and should be treated as such when being used to evaluate real estate investments.
Earlier we mentioned how ROI and IRR have a lot of similarities but considerable differences. The biggest is that IRR takes into consideration the time value of money. For example, if a project has a much shorter timeline than another being considered it could have a much higher IRR. On the flip side, a project with a longer timeline may have a low IRR but it is earning returns slow and steady. If you’re not evaluating investments with multiple metrics, you could 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, the cost of capital, and the opportunity costs you will incur as an investor. It’s a good idea to develop an investment strategy that fits your lifestyle by setting goals that are attainable and establishing your comfort level with the risks involved.
For example, our friend Alex is a real estate investor who prefers to invest in real estate deals with a 25% IRR or higher. They were recently presented with an investment opportunity that had a bit more risk involved and a 20% IRR with less development time. Alex is willing to pursue this project because the IRR is high enough and it will require less time and effort from them.
There are many moving parts to investing that need consideration. For Alex, they were willing to take on a bit more risk with less effort on their part for a quicker return on their investment.
As a general rule, a higher IRR is better than a lower one when all other contributing factors are the same.
The Bottom Line
It’s important when investing to understand how your money works for you. It’s also a good idea to determine your level of risk and how long you’re willing to wait for your return on investment. If you’re new to investing, we recommend speaking with a financial professional to discuss your options.
When evaluating your next move, be sure to use all the tools at your disposal to ensure your investment works for you. If you’re ready to get started in real estate investing check out the Learning Center to learn more.
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