What is IRR (internal rate of return)?

IRR, or internal rate of return, is a profitability metric used in the real estate industry that gauges the growth of an investment over time. The real estate industry has many ways to measure a property’s return, including return on investment (ROI), which offers a simple calculation to figure out how much money an investment will generate. However, IRR uses a standard calculation to show you the rate of growth over the length of your investment, allowing you to project future profits as a percentage and easily compare investments.

Key takeaways:

• Internal rate of return, or IRR, is a metric that estimates the annual return you can expect on an investment based on cash flows.
• An acceptable IRR varies based on the risk of the investment.
• IRR can be used to compare potential investment options to determine which one to pursue.

IRR basics

Internal rate of return measures the average annual return you can expect from an investment over its lifetime, accounting for when money comes in and goes out.

For example, a 15% IRR means the investment is expected to grow at an average rate of 15% per year. However, this calculation recognizes that receiving $1,000 today, for instance, is more valuable than receiving $1,000 5 years from now because money received earlier can be reinvested to generate additional returns. Return on investment doesn’t account for this difference in value. IRR is also preferred when evaluating investments because it can factor in the effects of inflation.

Understanding how IRR is used

Investors use IRR to estimate a potential 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 would be a better use of your capital.

Here are some different ways you can use IRR:

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

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 5 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 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).

While a higher IRR is better, it doesn’t account for how much risk and effort an investment will require. Different investors will have different risk tolerance levels, which will influence what they consider an acceptable rate of return. Expected returns can also be influenced by market conditions at the time of the investment. Generally, the riskier and more time-consuming an investment, the more you should discount its projected IRR.

What is the IRR formula?

The IRR calculation uses three key variables: the initial investment cost (what you pay upfront), net cash inflows (incoming funds minus outgoing expenses), and net present value (the current value of future cash flows). IRR is found by determining which rate makes the net present value equal zero.

Here’s the formula:

0 = NPV = ∑ (Ct  ? (1 + IRR)t) − C0

Where:

• NPV = net present value, or the present value of future cash flows
• Ct= net cash inflow during the period t
• C0= total initial investment
• t = number of time periods, commonly months or years
• IRR = internal rate of return

Calculating IRR in Excel

While you can calculate IRR manually, it’s not practical since it can’t be solved algebraically but requires a lot of trial and error.

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.”

What are the limits of IRR?

Despite its many uses, IRR isn’t without limitations, so you shouldn’t lean on it exclusively. To build a real estate portfolio, you must evaluate investments with a variety of metrics. Here are some situations where IRR can fall 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.

Although IRR is a great way to estimate the future returns in simpler situations, more complex investments should be evaluated with multiple metrics.

IRR example

To see how timing alters this metric dramatically, let’s compare two hypothetical properties. Imagine you invest $300,000 into Investment A, a triplex that yields a steady net operating income of $30,000 per year for four years, and then sells for $450,000 in year five.

Now consider Investment B, a single-family three-bedroom, two-bath property where you experience high vacancies early on — yielding just $6,000 in years one and two — but flips for a massive $540,000 in year five. Even though both investments might net you a similar total raw profit over time, Investment A will have a significantly higher IRR because it generated stronger, more consistent cash flow early in the cycle.

IRR vs. compound annual growth rate (CAGR)

IRR is sometimes confused with the compound annual growth rate (CAGR), but they serve completely different purposes. The biggest difference is that CAGR is designed for a single lump-sum investment that grows smoothly over time without any intermediate cash inflows or outflows, such as a traditional stock or index fund.

IRR, on the other hand, is meant to handle complex, irregular cash flows, making it more ideal for real estate projects that involve regular rental income, unexpected repair expenses, and an eventual resale.

The bottom line: Understand the meaning of IRR

IRR is a powerful metric for measuring the average annual return of an investment while accounting for the timing of cash flows. While it can help you compare investment opportunities and make more informed decisions about how to allocate your capital, it should be used alongside other metrics like ROI and CAGR for a fuller picture.

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