Internal rate of return (IRR) is one of the rate of return measurements more widely used during a real estate analysis for good reason: The aspect of time value of money associated with internal rate of return considers that the timing of receipts from the investment property can be as important as the amount received.
Unlike some other popular returns used by investors to analyze the performance and profitability of rental income properties that don't account for the time value of money such as capitalization rate and cash on cash, IRR does.
As a result, internal rate of return is generally more popular amongst real estate investors than other rates of return because it calculates for time value of money and provides a linkage between present value (PV) and future (FV) of any benefit stream.
The idea is straightforward.
Because a dollar in the hand today is preferable to one a year or five years from now, real estate investors want to take into account both the timing and the scale of cash flows generated by the income-producing property to determine what that rental income stream is worth today. Internal rate of return reveals the rate at which future cash flows must be discounted to equal the amount of investment exactly.
How IRR Works
Internal rate of return reveals in mathematical terms what a real estate investor's initial cash investment will yield based on an expected stream of future cash flows discounted to equal today's dollars, not tomorrow's dollars.
Consider this.
When you make a real estate investment, you are investing cash in order to receive a series of future annual cash flows resulting from rental income plus a tidy profit when you sell the property.
The challenge for real estate investors, then, is to discover what rate of return the investor's initial equity will make based upon those periodic future cash flows at the same time it considers the number of time periods (years) under consideration in the holding period.
The internal rate of return model meets that challenge by creating a single discount rate whereby all future cash flows can be discounted until they equal the investor's initial investment.
How to Calculate
Calculating IRR manually is not practical because the calculation involves tedious mathematical solutions that take a lot time. Even skilled real estate analysts typically use a financial calculator or real estate investment software program to compute it.
So we'll ignore the formula (you can find it online if you really care to know it) and instead consider what it signifies.
Let's assume that you have $300,000 to invest in an income-producing property and plan to hold it for seven years. During those years, you plan on receiving five annual cash flows and then an additional amount from the sale of the property (also known as reversion). When you find the unique rate of return that discounts the sum of all those future cash flows until it equals your initial investment, you will have the internal rate of return.
In other words, it shows you what your cash investment will yield for those cash flow projections based upon today's value of the dollar, or as if those cash flows were collected today rather then in the future.
You should not, of course, rely on one single element of a real estate analysis to the exclusion of other factors and measurements to make your investment decision. But internal rate of return can help point you in the right direction and guide your purchasing decision so plan to use it.
One final thought. If you are serious about real estate investing, then it is highly recommended that you invest in a real estate investment software solution. In this case, you not only will get a wide range of essential returns that includes IRR, but also benefit from all real estate analysis features that quality investment software provides.
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