IRR (Internal Rate of Return) is another fundamental tool of real estate investment – a calculation that is frequently used to determine the potential value of an investment. Investopedia defines IRR as “a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.” In layman’s term, IRR reflects the average annual return over the lifetime of an investment. It helps analysts, fund managers and investors determine when a project is likely to break even.
WARNING – The following formula used to calculate IRR is intimidating and enough to send some would-be real estate investors running back to stocks and bonds or even a simple money market. Never fear! It is only complicated because it is based on assumptions. Modern technology, financial calculators and Excel spreadsheet templates make IRR calculating accessible to all, but it is still advisable to have a working understanding of the logic that goes into these calculations. If you agree – keep reading. If you disagree and feel a strong headache coming on already, skip the equation and go directly to the explanation.
The Internal Rate of Return Formula
a + NPVa (rb – ra)
(NPVa – NPVb)
ra = Lower Discount Rate
rb= Higher Discount Rate
NPVa = Net Present Value Using the Lower Discount Rate
NPVb = Net Present Value Using the Higher Discount Rate
Solving the IRR equation by hand is a time-consuming and inexact process. It involves trial and error with varying values assigned to “r” until the NPV = “0”. Are you still confused? Don’t feel bad. The good news is that IRR is easily calculated using Excel, real estate software or a financial calculator. For newbie investors, it is far more important to understand why IRR is important than to understand how to calculate it.
Applying the Formula
Let’s start with an oversimplified example. Joe Smith makes an initial $1000 investment in a crowdfunded real estate venture. Over a 5-year period, there is no cash flow. At the end of 5 years, Joe’s shares are worth $1,610. The initial investment generated an annualized profit of 10%, so the IRR is 10%. Take that same $1,000 investment and put it into a project that promises investors 10% in annual distributions (or $100 in Joe’s case). After 5 years upon the sale of the property, Joe’s $1,000 investment is returned in full. In this example, the IRR still equals 10%. Of course, these examples are deliberately simple for illustration purposes. In real-world situations, income and expenses on the project would probably vary over time. A refinancing or tenant turnover midway through the project would impact the numbers significantly.
In general terms, the higher the IRR, the better. When comparing different properties or development projects, assuming the investment costs are equal, the property with the highest IRR should pique your interest and merit further review. If you are borrowing money the IRR should always be higher than the cost of money for the borrowed funds. Most importantly, IRR should never be the only calculation used to evaluate an investment. It is an estimate based on several assumptions and is most useful when paired with other metrics to weigh the merits of an offering.