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The internal rate of return (IRR) is one of the more preferred rates of return used by real estate investors trying to measure a rental property’s financial performance. This is because it calculates the time value of the money. It is defined as a discount rate at which the net present value of a set of cash flows equals zero.
Here’s the idea. IRR is the rate of return an investor can expect on the invested capital to purchase a rental property based upon anticipated future income streams. The future income divided by the initial investment is equal to the rate of return. This is the rate at which real estate investment grows. In this sense, you can consider it as an annual complex as a time sensitive compounded annual rate of return.
In addition, because it provides a combination between the present value and future value of the income stream, it allows the investor to consider the timing and scale of cash flows generated by the investment. IRR accounts for the time and value of money, unlike other general returns used investors.
How IRR Works
The internal rate of return reveals in mathematical terms what an initial cash investment will generate based on an anticipated stream of future cash flows discounted to equal today’s dollar value.
Let’s Consider This
When you make an investment in real estate, you’re investing money to receive a series of future cash flows arising from rental income including a tangible profit when the property is sold. The hurdle for real estate investors, is to discover what rate of return the investor’s equity will make based on those periodic future cash flows considering the holding period. IRR model satisfies this challenge by creating a single discount rate by which all future cash flows are discounted until they equal the investor’s initial investment.
How to Calculate IRR
You need an algebraic formula to calculate IRR. Manual calculation of IRR, therefore, is not practical because the calculation is tedious and takes a lot of time. But you can access excellent online real estate software, financial calculators or Excel templates that make the calculation much easier.
Example:
Say you’ve $ 200,000 to invest in a rental income property and plan to hold it for ten years. During those years, you plan to receive ten annual cash flows, and then an additional amount of the property’s sale. When you discover the rate of return that discounts the sum of all those future cash flows until it is the same with your initial investment, you’ll have the internal rate of return.
In other words, what your investment will generate for those cash flow projections based on the current value of the dollar. Of course, no single element of real estate analysis should determine an investment decision to the exclusion of other factors and measurements. But IRR can help guide your purchasing decision so plan to use it.
IRR Excel Spreadsheet: Here is a link to an excellent IRR Excel Spreadsheet and a video that explains how to use the spreadsheet: https://www.youtube.com/watch?v=b0w6LWv4mYQ&t=275s
Bill Manassero is the founder/top dog at the “Old Dawg’s REI Network,” a blog, newsletter and podcast for seniors and retirees that teaches the art of real estate investing.
