What is IRR?
The internal rate of return is a metric used by many industries, not only real estate. The IRR determines the overall rate of return by comparing the sale price, the purchase price, and the yearly cash flow. The crucial aspect of IRR is that it takes into account the time value of money, an essential concept in finance. The time value of money quantifies how much value is in the investment.
When looking at real estate investment properties, investors often evaluate real estate deals by their IRR (internal rate of return) along with other metrics. This metric helps investors understand the potential upside of an investment property. Moreover, IRR also determines real estate sponsor promote.
Why is IRR important for real estate? Let’s talk about this statistic in detail.
ROI vs. IRR
A lot of people get confused between IRR and ROI. The difference is straightforward: ROI calculates the growth of your investment over the total period, and the IRR calculates the annual growth.
IRR in real estate
In real estate investments, IRR estimates the average annual return that property has yielded or will yield over a specific period. This number is calculated as a percentage, and you can use it to compare the IRR you forecast to receive in real estate against the IRR you may receive in another kind of investment. IRR calculation must be done during your due diligence, along with other statistics.
Because IRR measures the time value of money, it tells you which initial investment will bring you better returns because 30% ROI in 3 years is not the same as 30% ROI in 10 years. Let’s look at this example:
In this example, both scenarios have equal profits. However, in scenario No 1, an investor received the profit incrementally over the 5-year hold period. In the meantime, in scenario No 2, you don’t receive any cash flow throughout the hold period, and you get all your profit along with your principal at the end of the entire holding period of 5 years.
At first glance, it may seem that both of these scenarios are equally profitable. We’ve calculated IRR using an Excel formula like this one:
We can see that scenario 2 has a lower IRR because there is no cash flow. Cash flow offers you an opportunity to reinvest it somewhere else and generate even more returns with that capital. Therefore, there is an opportunity cost that you need to take into account when evaluating investments. As a real estate investor, you should be looking at IRR in addition to cash on cash return and equity multiples.
IRR components
There are several crucial components involved with IRR calculations in real estate and here is the formula that expresses those components:
N = The total number of hold years
Cn = The cash flow in the current period
n = The current period
r = The internal rate of return
It’s essential that you understand these statistics to comprehend IRR fully.
Net Present Value (NPV)
Net present value is the difference between the present values of all cash outflows and all cash inflows. NPV indicates whether your investment is achieving a target return at a specified initial investment. NPV also tells you what adjustment you need to make to the initial investment to achieve the target return, assuming everything else remains unchanged.
To calculate the NPV, subtract the present value of cash outflows from the present value of cash inflows.
Discount Rate
Above, we mentioned opportunity cost, also known as the discount rate. Let’s say you can earn 10% a year on your cash guaranteed. In this case, your discount rate would be 10%. Ten-year Treasury bonds are considered risk-free investments and can generate cash. Therefore, investors often compare the discount rate against a ten-year treasury bond. Generally speaking, your real estate investment comes with risk and must be above any guaranteed return.
Cash Flow
Cash flow is the amount of money your real estate investment generates for you each year (distributions). For example, if you invested in a real estate multifamily deal and receive $5,000 every three months in distributions (rent income), you have a positive cash flow of $20,000 a year. If you are using our real estate investor portal to manage your deals, you will see this chart with a cash flow history that helps you understand whether your deal generates positive cash flow.
What information can you get from IRR?
In general, a high IRR tells you that the real estate deal might be worth investing in and helps you evaluate real estate investments. However, IRR alone doesn’t take into account future expenses, property appreciation, and risk tolerance. Let’s take a look at the limitations of IRR.
Limitations of IRR in real estate
- IRR calculations are mostly based on assumptions or forecasts, such as cash flow, future sale price, and discount rate. In real estate, some factors are too complex to forecast accurately. They include rent vacancies that could seriously affect your cash flow and drop your IRR
- IRR does not give you a comprehensive comparison of different size projects. For example, if you compare a $1,000,000 property with 15% IRR against one that costs $6,000,000 and has an IRR of 10%, you will find that even though a smaller property produces a higher IRR, it is still less cash than a bigger property with lower IRR yields.
Conclusion
The bottom line is that IRR can be an effective metric to use when analyzing real estate investments. It provides a numerical value instead of just qualitative values, and it accounts for the time value of money. Ideally, investors want to find properties with the highest IRR to ensure a high return on their investment.
You might not know about the IRR for real estate when you’re first starting out, but this metric could help you secure a great investment property. Once you start investing in real estate deals, it is important to understand IRR for real estate to know if you are getting a good return on your investment.
Understanding these concepts will help real estate investors make better real estate decisions, whether you’re starting out with passive real estate investing or syndicating a deal. Before investing in any property, it pays to do your research. Sometimes the numbers don’t work out, but if they do, IRR can offer a fascinating look at the potential upside of a particular investment property.
