Real estate investors track many different financial metrics to get a sense of their investment, or the potential upside of an investment. One of those metrics is the internal rate of return, also known as the IRR.
What is IRR in real estate, and why should you care? We’ll be covering this important statistic in greater detail below!
How Does IRR Work in Real Estate?
The internal rate of return is used in many different industries, including real estate. The IRR compares the purchase price, yearly cash flow, and sale price, to determine the overall rate of return.
What Is IRR?
What is the IRR in real estate? Simply put, the internal rate of return is used to estimate the average annual return a property has produced or will produce, over a specific period of time.
This figure is calculated as a percentage, and it allows you to compare the internal rate of return you may receive in real estate against the internal rate of return you may receive in another investment.
What Does IRR Tell You?
The IRR is a profitability calculation. It measures your profitability as an overall percentage.
For example, if you are comparing 3 different real estate investments, each property will have its own IRR.
- Property A may have an IRR of 12%
- Property B may have an IRR of 15%
- Meanwhile, Property C may have an IRR of 5%
If you’re looking to maximize your return, property B would be the property you’d want to go with, assuming all other financial metrics point in this direction – such as risk.
What Is a Good IRR for Real Estate?
Generally speaking, the higher the IRR is, the better the deal is. Better is simply being defined as the most profitable.
With that said, risk tolerance, future expenses, and the property’s appreciation must also be taken into consideration.
How To Calculate IRR
If you’re wondering how to calculate the IRR in real estate, hang tight. At first, this formula may seem a bit confusing, but with a bit of practice, you’ll be able to quickly understand the mechanics. Additionally, the IRR is more easily calculated using a spreadsheet, such as Excel or Google Sheets.
To calculate the IRR, you need to make some predictions. Such predictions include:
- The annual distributions, or cash flow, the property will produce
- The future date the property will be sold
- The price the property will be sold for
Additionally, you’ll need to know exactly what the property cost when initially purchased.
Example of Calculating IRR in Real Estate
Below is an example of calculating the internal rate of return in excel.
|After Tax Cash Flow||$15,000||$15,000||$17,500||$19,000||$19,000|
|Total Cash Flow||-$300,000||$15,000||$15,000||$17,500||$19,000||$394,000|
The numbers in the top row represent the year. Year “0” indicates the purchase price of the home.
In the subsequent years, the property produces cash flow as shown in the “After-tax cash flow” row. Finally, in year 5, the property is sold for $394,000. The IRR is 9.74%.
An IRR calculator in real estate can also be found online. You’ll need to know all of the numbers (purchase price, yearly cash flow, and sale price), but the software will do all the calculations for you.
Factors Involved with IRR in Real Estate
There are numerous statistics required to fully understand the IRR.
Net Present Value (NPV)
The net present value is a simple formula. To calculate the net present value, take the present value of the cash inflows and subtract the present value of cash outflows.
To understand the net present value, you’ll need to understand the following:
- Expected net cash flow amount for a specific period of time
- The projected length of the investment
- The discount rate, which is also known as the opportunity cost
The discount rate is also known as the opportunity cost. If you can earn 5% a year on your cash guaranteed, your discount rate would be 5%.
The discount rate is often compared against a 10-year treasury bond, as that is considered a risk-free investment and can generate cash. A rule of thumb is your real estate investment should be above and beyond any guaranteed return as real estate investing comes with risk.
Cash flow is defined as the amount of money the property produces each year. For example, if you rent your home and your pure profit (after taxes and expenses) rent is $1,000/month, you have a positive cash flow of $12,000 that year.
Advantages of Using IRR in Real Estate
Advantages of using the IRR in real estate include:
- The internal rate of return leverages the time value of money
- Using the IRR allows you to compare profitability across numerous real estate investments and varying cash flows
- The IRR can be custom to the investor, as you can choose your own realistic discount rate
More Info: Benefits of Investing in Real Estate
Disadvantages of Using IRR in Real Estate
Disadvantages of using the internal rate of return in real estate include:
- Much of the equation is based on assumptions, such as a future sale price
- There are factors in real estate that are impossible to predict, such as rent vacancy. That could drastically affect your cash flows, and throw off your internal rate of return
- The internal rate of return struggles to compare projects of different scales. For example, comparing a $300,000 property against a $1,000,000 would be challenging. If the $300,000 property produces a 15% IRR, that is still far less cash than a $1,000,000 property producing a 10% IRR.
IRR vs ROI
The main difference between the ROI (return on investment) and the internal rate of return is the fact that the return on investment calculates the total growth of an investment, whereas the IRR calculates the yearly annual growth.
There’s a lot to be Mindful of
If you’re planning on making any investment, there is a lot of information you should be mindful of. Knowing the various profitability metrics can help you maximize your return and reduce your risk.
If you’re new to the investing world, consider working with a financial advisor. Not only will a financial advisor help you diversify your investments into various asset classes, a good financial advisor will also help educate you along the way.