What is IRR in Real Estate?
When investing in an income-producing asset, it’s important to know how much money you will make as well as when you will receive it.
Checking the performance of stocks and bonds can be easily done by logging into a brokerage account for updates. However, identifying current and future real estate returns is much more difficult because the same property does not change hands every day.
Of the various financial analysis metrics available to real estate investors, IRR is one of the most often used calculations. IRR in real estate incorporates key investment criteria to help identify property that meets the specific goals of each individual investor.
What is IRR?
Internal rate of return (IRR) is a financial metric used to measure the profitability of an investment over a specific period of time and is expressed as a percentage. For example, if you have an annual IRR of 12%, that means you have 12% more of something than you did 12 months earlier.
The IRR calculation combines profit and time into one formula:
Profit is how much cash the investment generates over the holding period compared to the amount of capital invested
Time value of money (TVM) estimates what the current value is of money received in the future
Opportunity cost by comparing the IRR of one investment to other alternatives
A good way to think about IRR is that it is the discount rate – or interest rate – that makes the net present value (NPV) of the cash flows you receive equal to zero.
By weighting the periodic cash flows, IRR helps you to make a fair comparison to alternative investments with cash flows that occur at different points in time. That’s because a dollar actually received today is worth more than the promise of a dollar received several years from now, due to factors such as inflation, unknown future events, and general investment risk.
As a real estate investor, you have a required rate of return on the capital being deployed in order for the investment to make sense. Everything else being equal, the investment that generates an IRR greater than or equal to your required rate of return will be worthwhile taking a closer look at.
Examples of calculating IRR
Let’s assume you invest $100,000 in a property with a holding period of five years. If you choose the wrong investment and have no cash flows and no profit or loss at the time of sale, your IRR is 0%.
However, the three more likely potential outcomes are:
#1: Annual cash flow and no profit from sale
Initial investment $100,000
Annual cash flow $12,000