The internal rate of return (IRR) has become an accepted way to gauge the profitability of a real estate investment.
Well, if you want to check up on investments like stocks or bonds, it’s relatively easy to do so.
All you have to do as an investor is log onto a financial news website or brokerage account to see how your holdings are performing.
As a private asset, however, real estate isn’t quite as clear.
It doesn’t give you the same visibility into daily pricing and performance.
Thus, you need more complex calculations like the IRR to determine whether a property is a good investment.
Keep read to learn more about IRR and how you can use it in real estate.
1. What is the internal rate of return in real estate?
The internal rate of return (IRR) is a metric that tells investors the average annual rate of return they have either realized or can expect to realize from a real estate investment over a period of time.
It is expressed as a percentage.
The idea behind the internal rate of return is a combination of the measure of both profit and time in a single metric.
Profit = how much cash an investment generates relative to the amount you invested
Time value of money = inflation affects the value of money over time, which means a dollar today is worth more than a dollar five years from now.
Ex: $1 today may only have $0.90 of buying power in 2022
Keep in mind that each investment has a trade-off, also known as an opportunity cost.
If you choose to invest in project A, it may mean that you’re forgoing the opportunity to invest in another project (Project B).
If you receive a dollar today, you could invest that dollar and earn a return.
However, if you receive that dollar in the future instead of immediately, then you are effectively missing out on potential returns.
2. How can real estate investors use the internal rate of return?
The internal rate of return allows real estate investors to find a clear comparison across investment opportunities by appropriately weighting cash flows that occur at different times.
For most investments, the initial IRR is an estimate based on various assumptions.
That said, it can still be a valuable tool used to measure a project’s potential annualized return.
When the investment is sold, the actual final internal rate of return can be calculated.
3. What is the net present value?
While calculating the internal rate of return, you’ll likely see the acronym NPV used.
NPV stands for net present value, and it’s the difference between the present value of a property’s expected cash flows minus the initial investment amount.
When there’s a positive NPV, it’s ideal for investors as it means that the property will yield the desired rate of return.
However, when the NPV is negative, it means the property is likely to underperform.
In order to calculate the internal rate of return, you must set the NPV to zero.
4. What are the steps to calculating IRR?
Follow these steps to calculate the internal rate of return:
Use the formula above
Set NPV equal to zero and solve for the discount rate (the IRR)
The initial investment is always negative because it represents an outflow
Each subsequent cash flow could be positive or negative, this depends on the estimates of what the project delivers or requires as a capital injection in the future
Due to the nature of the formula, the internal rate of return cannot be calculated analytically.
Instead, you must calculate it iteratively through trial and error using software programmed to calculate IRR.
We recommend using Excel.
5. How can you calculate the internal rate of return for commercial real estate investments?
The internal rate of return aims to provide investors with an expected return based on cash flows that vary over time.
An IRR calculation levels those cash flows by expressing a single percentage, which is the annual rate at which the net present value (NPV) of those cash flows equals zero.
The mathematical formula for the internal rate of return finds the discount rate (also known as the interest rate) that sets all the project’s cash flows to an NPV of zero.
If a project has a positive IRR, then investors have earned a return on their investment.
If a project has a negative IRR, then investors have lost money on their investment.
Calculating the internal rate of return for investments involves the following assumptions.
The level of annual distributions to investors
The date at which the project will be purchased
The price at which the project is sold
Each of these assumptions above will be measured in relation to the initial cost of the investment.
6. What are some examples of internal rate of return in real estate?
Below are a couple of examples of how IRR is calculated.
Example 1: The IRR of a five-year investment with no yearly distributions
Here are the conditions:
Assume the initial investment is $1,000
Assume that no cash flows are received over the five-year holding period
Assume the initial $1,000 is recovered at the end of year five
In this case, the real estate IRR would equal zero.
This is because no cash flows were received.
The initial investment was recouped after five years, and the investment did not generate any additional profits.
Example 2: The IRR of a five-year investment with no yearly distributions and a profit
Here are the conditions:
Assume the initial investment is $1,000
Assume no cash flows are received over the five-year period
Assume the initial investment is sold for $1,610
The real estate IRR would be 10% because the value of the investment appreciated from $1,000 to $1,610 (10% compounded annually).
This occurred despite no cash flows being received in the interim.
Note: These examples are extremely oversimplified, and actual cash flows from a project will typically involve varying annual cash flow amounts.
7. What are the advantages of using the internal rate of return for real estate investments?
The internal rate of return tells you a lot about the property, which is why it’s a metric that investors use.
Here are some of its best benefits:
Time value of money: the timing of all future cash flows is considered, and thus, each cash flow is given appropriate weight by discounting the time value of money.
Simplicity: IRR is an easy metric to calculate, and it provides a simple means by which to compare various real estate projects.
Hurdle rate not required: IRR does not require the use of a hurdle rate.
This mitigates the risk of determining a vastly divergent rate.
IRR can be calculated independently of the use of such rates, and investors can then compare their own individual estimated cost of capital to the IRR as they choose.
That said there are some drawbacks to the IRR, and you want to be wary of this.
In the next section, we’ll dive deeper into the disadvantages and how you can keep them in mind as you’re using this metric to guide your investment decisions.
8. What are the disadvantages of using the internal rate of return for real estate investments?
Although using the internal rate of return in real estate has its advantages, real estate investors shouldn’t solely rely on IRR to guide their investment decisions.
Firstly, a higher IRR doesn’t mean your project is a better investment.
There are a variety of factors that can help you determine whether or not a project is a good investment.
For example, an internal rate of return doesn’t consider the size or the risk profile of a project.
Nor does it take into account the time frame over which that return will be generated or the actual dollar amount of profit to be realized.
Real estate projects are risky, and these risks (i.e., rental rate, occupancy, etc.) can be difficult to accurately project.
Additionally, IRR relies on assumptions and projections from managers, and it’s entirely possible for these to be misrepresented or misled.
Thus, investors must assess the underlying assumptions and how valid they are before making an investment decision based solely on the stated internal rate of return.
Like any estimate, an IRR is simply a projection.
The actual results that occur can vary materially from an investor’s expectations.
9. How can you guard yourself against risks associated with the internal rate of return?
If you’re a real estate investor, you should consider using the internal rate of return WITH other metrics, like the equity multiple.
The equity multiple is calculated by dividing the total cumulative cash flows over the life of the project by their initial investments.
Equity multiples don’t include the time value of money in their calculation, and thus it’s helpful to also include the internal rate of return as another component in your considerations.
Using the internal rate of return along with another metric can help investors contextualize both other real estate opportunities and investment offerings.
The end goal is understanding both past and potential returns across the investing spectrum.
10. Why should you care about the IRR formula?
As a smart real estate investor, you want to earn money on what you’re investing in.
After all, isn’t that the point of investing?
When you utilize the IRR formula, you help yourself understand whether the property will generate the returns you hope for or if a different investment will help you do that better.
That said, all the assumptions made about the data that you put into the formula must be as close to accurate as possible.
Otherwise, your results will be skewed.
The IRR is a tool that can help provide a window into the predicted returns and the value of money over time.
That said, it’s not the only metric you can use.
Others include cash flow, cash on cash return, and cap rates.
Just keep in mind that the internal rate of return is only one of the tools in your tool belt as a real estate investor!
11. What’s a good IRR?
Are you looking for an IRR that makes an investment worthwhile?
The term “good” is incredibly relative.
We like to describe a “good” IRR as one that you feel reflects a sufficient risk-adjusted return on your cash investment given the nature of the investment.
That said, it’s important to remember that the IRR’s calculation (which is annual) is biased by the investment timeline and the timing of cash flows within that timeline.
All that said, here are some sample IRRs for various investment types:
Acquisition of stabilized asset – 10% IRR
Acquisition and repositioning of an ailing asset – 15% IRR
Development in an established area – 20% IRR
Development in an unproven area – 35% IRR
The internal rate of return (IRR) is one important metric you can use as you evaluate a real estate investment opportunity.
Additional ResourcesIf you are looking to buy affordable land, you can check out our Listings page. And before you buy land, make sure you check out Gokce Land Due Diligence Program. If you are looking to sell land, visit our page on how to Sell Your Land.
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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.