As a real estate investor sooner or later you’ll be confronted with deals advertising an Internal Rate of Return (IRR). It’s an important metric to pay attention to but can be a bit complicated to understand. What exactly is IRR, and how do you calculate it? Understanding IRR’s definition will help you make informed investment decisions and more easily compare various investment options.
What is the Internal Rate of Return?
In a nutshell, the Internal Rate of Return (IRR) is a metric that measures the profitability of an investment. Put simply, it tells you what return you can expect to earn on your investment over time.
To calculate IRR, you take into account the expected cash flows from the investment and then compare them to the initial capital outlay. The higher the IRR, the more profitable the investment is expected to be.
As a real estate investor, the IRR is an important metric to pay attention to because it can help you compare different investment opportunities side by side. I look at it as an equalizer. At its core function, the IRR tells you what type of return an investment will generate if you were to pay all cash for it. Meaning, if you look at a standard annual return calculation, it’s highly dependent on how the investment was financed. Higher leveraged assets will generate a higher return. (Assuming you can tolerate the risk of high leverage, and all goes well!) The IRR calculation gets rid of this variability by telling us how the property performs without a leverage consideration. It also incorporates cash flow over the life of the property, as well as inflation over the investment period. In short, it puts your investment options on a level playing field in order to evaluate those options.
How Do I Calculate the IRR?
There are a few different ways to calculate the IRR. The simplest way is to use a financial calculator or Excel spreadsheet. However, if you want to do the math yourself, the most common is the trial-and-error method.
To use this method, you’ll need to estimate what your property’s cash flows are likely to be over the course of its holding period. Once you have those estimates, plug them into an IRR calculator (you can find plenty of free ones online) and play around with different discount rates until you find one that results in a positive return.
The internal rate of return (IRR) is an important metric for real estate investors because it tells them what kind of return they can expect to earn on their investment over time. By paying attention to this metric, investors can compare different opportunities and make informed decisions about where to invest their money. Just remember to use caution when estimating future cash flows—after all, they’re only estimates!—and to consult with a financial advisor if you have any questions along the way.