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 the most skilled
investment real estate specialist will 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.
Say
you have $100,000 to invest in a rental income property and plan to
hold it for five 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.
Of course, no single element of a real estate
analysis should determine an investment decision to the exclusion of
other factors and measurements. But internal rate of return can help
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. |