The Internal Rate of Return (IRR) is a metric that tells investors the average annual return they have either realized or can expect to realize from a real estate investment over time, expressed as a percentage. The IRR is the discount rate that makes the net present value (NPV) of a project zero.
Example: The IRR for Project A is 12%. If I invest in Project A,
I can expect an average annual return of 12%.
The basic idea behind IRR is to combine a measure of both profit and time into a single metric. The goal of IRR is to provide investors with an expected return based on cash flows that vary over time. An IRR calculation levels those cash flows by expressing a single percentage: the annual rate at which the net present value (NPV) of those cash flows equals zero.
The mathematical formula for IRR therefore involves finding the discount rate, or interest rate, that sets all the project’s cash flows to an NPV of zero. A project with a positive IRR means investors have earned a return on their investment. A negative IRR implies a money-losing project.
Calculating IRR for real estate investments involves making a few assumptions: (1) The level of annual distributions to investors, (2) The date at which the project will be sold and (3) The price at which the project is sold. Each assumption is then measured in relation to the initial cost of the investment.
When calculating the IRR (noted as r above), the NPV of a project must be set to 0.
When calculating IRR, expected cash flows for a project or investment are given and the NPV equals zero. Put another way, the initial cash investment for the beginning period will be equal to the present value of the future cash flows of that investment. (Cost paid = present value of future cash flows, and hence, the net present value = 0).
Once the internal rate of return is determined, it is typically compared to a company’s hurdle rate or cost of capital. If the IRR is greater than or equal to the cost of capital, the company would accept the project as a good investment. (That is, of course, assuming this is the sole basis for the decision.
Calculating the IRR is an essential step for determining how your investment property is likely to provide a return over the years that it is held. It is important to note that for most real estate investments, the initial IRR is only an estimate based on a number of assumptions. However, it is still a valuable tool for measuring a project’s potential annualized return. Once the investment is sold, the actual final IRR can be calculated. Most importantly, a higher IRR doesn’t necessarily mean that a project is a better investment — many factors can determine
a project’s return. For example, an IRR calculation doesn’t take into consideration the size or risk profile of a project, the time frame over which that return will be generated, or the actual dollar amount of profit to be realized. Real estate projects can also carry risks that can be difficult to accurately project, such as rental rates and occupancy.
