What is IRR (internal rate of return)?

Imagine a 10-year real estate investment that returns $1,000 in the first year. Now imagine it doesn’t return the $1,000 until the tenth year. All else equal, which version would you prefer?

The second, of course. However, a simple return on investment (ROI) formula would show an identical return for these two investments. To account for the time value of money, investors must use more sophisticated metrics like Internal Rate of Return or IRR.

What is IRR?

Internal Rate of Return (IRR) is the compounded annual rate of growth of an investment.

It’s derived by assuming the time-discounted value of all future cash flows equals the cost of the initial investment. In technical terms, IRR is the discount rate at which the investment’s net present value (NPV) is zero.

What is the IRR formula?

Here’s the IRR formula:

0 = NPV = ∑ (C_t  ? (1 + IRR)^t) − C₀

Where:

• NPV = Net Present Value
• C_t= Net cash inflow during the period t
• C₀= Total initial investment costs
• t = The number of time periods
• IRR = The internal rate of return

Calculating the internal rate of return

Now that you know what the IRR formula is, here’s how to calculate it:

Calculating IRR manually

Calculating IRR manually involves an iterative process of plugging in different IRR (aka discount) rates until the NPV equals zero.

Since the IRR formula isn’t algebraically solvable, it’s best to use a financial calculator. However, these are the steps on how to calculate IRR generally: 

1. Set the NPV equal to 0 and solve for the discount rate.
2. The initial investment is always negative, reflecting an outflow,
3. The following cash flows may be either positive or negative, based on projected project returns or future capital requirements

 Calculating IRR In Excel

Fortunately, calculating IRR in Microsoft Excel (or Google Sheets) is much easier. The “=IRR” and “=XIRR” functions let you enter an investment’s various cash flows (and dates if cash flow intervals are inconsistent) to determine the IRR automatically. Here are the steps:

1. List the investment’s cash flows in separate cells.
2. Enter the =IRR or =XIRR formula in a new cell
3. Highlight the cash flow cells to include as “values”

Understanding IRR

Investors use IRR to estimate a prospective investment’s return rate and compare it against other potential investments. The higher the IRR, the better the investment.

For example, if buying a new rental property promises a 16% IRR and renovating an existing property in your portfolio promises a 22% IRR, the latter may be a better use of your capital.

An example of applying IRR

In real estate investing, IRR is a powerful tool for determining the profitability of a deal and how it compares to other potential investments.

A typical real estate investment may have multiple cash inflows and outflows. For example, you might spend $100,000 on a rental property, receive $1,000 in annual cash flow for the first five years, and then $1,100 in annual cash flow for the next 5 years.

IRR can give you a comprehensive view of this project’s profitability by giving you an annual return percentage that accounts for how much money goes in and out of your pocket and when.

What’s a Good irR?

Whether an IRR is good or bad is subjective. It depends on the cost of financing the deal (for example, mortgage rates and closing costs) and the opportunity cost of not investing the capital elsewhere (like in another real estate deal).

All else equal, a higher IRR is always better. Keep in mind, however, that IRR doesn’t account for how much risk and effort an investment will require. The riskier and more time-consuming an investment, the more you should discount its projected IRR.

How is IRR used?

IRR can be used in many ways:

• Investment analysis: IRR can help investors evaluate and compare the profitability of different projects.
• Project feasibility: Investors can assess the feasibility of a project based on whether the expected IRR justifies the risk and capital.
• Capital budgeting: IRR can help investors know where to deploy capital, prioritizing projects with the highest potential return.
• Cost of capital comparison: Investors can compare an investment’s IRR to the cost of financing the deal to determine whether it’s worthwhile.

How is IRR used with weighted average cost of capital?

Weighted Average Cost of Capital (WACC) measures a company’s average cost of capital where various capital sources (such as debt and equity) are weighted by their market value. Many firms use it as a hurdle rate, which potential investments must clear to be considered profitable.

In practice, this means an investment’s IRR must exceed a firm’s WACC to be worthwhile.

What are the limits of IRR?

Despite its many uses, IRR isn’t without limitations. To build a real estate portfolio, you must evaluate investments with a variety of metrics. Here’s where IRR falls short:

• Potential for multiple IRRs: If an investment’s cash flows are non-conventional (meaning they change signs from negative to positive or vice versa more than once), the IRR formula can yield multiple solutions, making it hard to know which is correct.
• Reinvestment assumption: IRR assumes that all cash flows generated by the investment are reinvested at the same rate as the IRR. However, this is unrealistic, and actual returns may differ as a result.
• No measure of size: IRR doesn’t account for the size of an investment’s returns. For example, a smaller project may have a higher IRR than a larger one, but the larger project may still generate more in total dollar value.

IRR example

To illustrate the use of IRR, consider the cash flow patterns of the following two investments:

Both investments have an investment period of 5 years and involve an exit sale in year 5.

To calculate each project’s IRR, enter the cash flows into the IRR formula in Excel. For Investment A, this yields a 10% IRR. For investment B, this yields a 14% IRR.

Assuming your cost of capital is 12%, you should pursue investment B and reject investment A.

IRR vs. compound annual growth rate (CAGR)

IRR and Compound Annual Growth Rate (CAGR) both measure the compounded annual return of an investment expressed in a percentage. However, CAGR uses only an investment’s beginning and ending values over a certain period and is easier to calculate, while IRR considers multiple cash flows and periods and is harder to calculate (at least by hand).

IRR vs. return on investment (ROI)

IRR and return on investment (ROI) both measure an investment’s performance expressed in a percentage. However, ROI shows an investment’s total growth from start to finish, while IRR shows an investment’s annualized return. Consequently, the two numbers will be roughly the same for investments that last one year but different for longer periods. In addition, unlike IRR, ROI is a simple calculation: ROI = Net Return / Cost of Investment.

The bottom line: Learning the meaning of IRR

Though not the right tool for every situation, IRR is a powerful metric every real estate investor should know how to use. It can help you evaluate and compare potential investments, determine if a project justifies the capital costs, and prioritize where to invest next.

If you’re ready to invest in real estate, start your mortgage application today! The sooner you put your capital to work, the sooner you can expect to see potential returns.