What Is Internal Rate Of Return (IRR) And How Is It Used To Make Real Estate Investment Decisions?
Emma Tomsich4-minute read
February 02, 2021
If you’re an investor or business manager eyeing a new real estate investment, you might be familiar with the term “internal rate of return,” or IRR. IRR is a metric used to analyze capital budgeting projects and evaluate real estate investments over time. IRR is beneficial for investors, business managers and real estate professionals alike, so it’s important to understand what it is and how it’s calculated. Let’s talk about IRR in real estate and explain how you can use it to ensure profitability.
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What Is IRR?
The internal rate of return is a way of comparing the future value of an investment to what that investment is worth in today’s dollars. By calculating what the investment will be worth, figuring out its equivalent in today’s dollars and comparing that to the amount of your investment, an investor can determine whether the investment will lose money or earn enough to make it worthwhile.
Therefore, investors use IRR as one metric among many when they are trying to decide how best to invest their assets, and when deciding whether or not a prospective investment is worth the risk.
In this article, we’re going to talk about IRR specifically pertaining to real estate, but it’s important to note that the IRR calculation is the same for all types of investments.
Before giving you the formula and other tips for calculating IRR, let’s further explain what IRR is and what it’s made up of.
The Importance Of Metrics
As previously mentioned, IRR is one metric investors 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.
The Time Value Of Money
Building off of IRR and NPV, let’s define time value of money, or TVM. TVM is the concept that your money now is worth more than the exact sum of your money in the future, as a result of its potential earning capacity. Following this principle, it can be said that money is worth more the sooner it is received because it can earn interest as time goes on. This term TVM can also be known as present discounted value.
Like TVM, IRR is also referred to as the discount rate; in other words, it tells how much the future returns of any investment is worth in today’s dollars. This number is also known as the net present value. This allows investors to compare prospective investments to one another or against their hurdle rate so that they can judge whether the investment is worth the risk.
How To Calculate IRR
Before going over the formula and other tips for calculating IRR, it’s important to let you know that no one expects you to calculate these formulas by hand because they involve calculus. Aside from old-fashioned pencil-and-paper math, you can find the IRR number by using a financial calculator or the IRR function in Excel. However, even if you’re not crunching numbers by hand, it’s important to understand the IRR formula, as well as what the math shows us.
The Hard Way
Before jumping to IRR, it’s first important to understand how NPV is calculated. Here’s the formula to calculate NPV:
i=Required return or discount rate
t=Number of time periods
Calculate IRR By Setting NPV To Zero
Now, let’s graduate to IRR. IRR is calculated by setting NPV to zero. It’s important to remember that IRR is the discount rate for which the net present value of an investment is zero.
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
The Easy Way
Luckily, if math isn’t for you, technology makes this calculation process much simpler.
Use A Financial Calculator
One way to calculate IRR using technology is with a financial calculator. A financial calculator will calculate these values for you.
Use The Formulas Built Into Excel
A second way to calculate IRR using technology is on Excel. Excel has a built-in IRR calculator.
IRR Vs ROI
ROI, or return on investment, is another important metric investors use. ROI is calculated by taking the difference between the current or expected value and the original value divided by the original value and multiplied by 100. While there are some similarities between the two, there are also many differences. For example, ROI is more widely used than IRR, as it is easier to calculate. In addition, the main difference between the IRR and ROI is that ROI calculates the total growth of an investment from start to finish, while 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. So, let it be known that ROI doesn’t take into consideration TVM, while IRR does. Therefore, while these two calculations may seem alike over the course of one year, they will not be the same when studied over longer periods.
Limitations Of The IRR Metric
Before you start making calculations, it’s important to understand exactly what IRR is telling you. It’s also important to be aware of the common mistakes investors make when using IRR. For example, investors should not use IRR exclusively, but rather supplement it with at least one other metric. As you continue to think about your future investments, make sure to discuss these opportunities with your financial advisor to make sure the information is being interpreted correctly.
If you take away one key message from this article, make it the importance of understanding IRR as a metric when evaluating an investment opportunity. As you continue to expand your knowledge about investing, make it a goal to learn more about getting approved for a mortgage today so you can start investing in real estate.