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Internal Rate of Return in Real Estate Analysis |
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| Thu Sep 24, 2009 11:28 am MST |
 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. |
Investment Decisions for Real Estate Investors |
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| Wed Sep 23, 2009 3:07 pm MST |
 The investment decision real estate investors make as to whether or not
to purchase a rental property ultimately requires serious number
crunching that measures the property's financial performance.
But
even prudent calculations without first collecting some raw data
related to the market (to shape an offer) and then about the property
itself (once an offer is written) will not guarantee that the investor
is making the most prudent investment decision.
In this article,
we'll briefly discuss both the market and property data investors must
consider before and during the investment process.
The Market Data
Before
a real estate investor can decide on how much to offer for a rental
property, he or she must understand as much as possible about the
conditions of the real estate market surrounding the property in order
to structure a meaningful offer.
We recommend that investors survey and collect data on at least these three market indicators.
1)
Comparable Sales Conducting a survey to see what other similar income
properties have recently sold for is a proven way to evaluate whether a
seller's asking price is in line with realistic property value. Keep
the sold comparables as recent as possible (perhaps within the past six
months to one year) and the properties themselves as comparable as
possible. You want to look at rental properties similar in usage,
location, size, and condition to the rental property you are
considering. Real estate agents are generally prepared to do this for
you, or you can conduct your own survey by researching the public
records at local tax assessor's office or making a call to several real
estate appraisers.
2) Rental Rates and Expenses Conducting a
survey to see what tenants are willing to pay for space and owners are
obliged to pay for operating expenses in the surrounding area for
similar kinds of rental property is also valuable information. Just be
sure that the rents you survey reflect similar unit configurations such
as number of bedrooms and baths, size, and so on as well as property
location, condition, and amenities. It would be misleading to think
that the subject property (say, an apartment complex in a C location in
poor condition) will generate the same rents as a recently remodeled
apartment complex in an A or B location for instance.
3)
Capitalization Rates Knowing what the typical capitalization rate is
for a particular kind of property inside a market area is very helpful.
By knowing at what cap rates other similar rental properties have been
selling for gives you a hint on how to structure an offer. If you
aren't aware of what a cap rate is, or how to calculate it, you should
find out because cap rates are one of the more important returns used
in real estate investing; a qualified broker with knowledge about real
estate investing or various resources online should provide the answers
you require.
The Property Data
Once you have an
acceptable offer, it is then incumbent upon you to be sure that the
numbers used to make the subject property's cash flow calculations are
truthful and correct. Remember, real estate investors purchase an
investment property's cash flow (or income stream). We recommend that
you validate the accuracy of at least these elements during your due
diligence; obtain from the seller or in some cases indirectly from
other sources.
1) Leases and Rental Agreements - You become
subject to the terms of the leases and rental agreements if you do buy
the property, so examine tenant agreements closely. What do they say
about rental rates, renewal options, and termination? How long does
each lease run? Do they agree with the seller's representation of the
property's income? You must be able to count on the current figures to
make forecasts about the rental property's future performance.
2)
Property Tax Bill - By looking at the property's tax bill, you can
confirm the accuracy of this expense. You might even uncover whether
some sort of tax abatement granted to the current owner that might
expire or not apply to you as the new owner, or maybe some other tax
issue that could impact you negatively.
3) Utility Bills - At
least spot-check what the owner has been paying for gas, electric,
water and sewer. Most utility companies will give you usage information
if you call, and the information can be a useful way to discover
discrepancies in the operating expenses presented you for the property.
4)
Maintenance Records - Look for how much and where the owner has been
spending money to maintain the property. Normal wear and tear can be
expected, but repetitively having to replace broken windows, for
example, can be an indication of tenant or neighborhood problems.
5)
Seller's Schedule E Tax Return - This information is helpful because
you see the income and expenses the seller has been reporting to the
IRS about the property. It's quite unlikely that an owner will claim
too much income or too little expense on a tax return, so this can be
an illuminating source of information. Just be sure to include a
request to see the Schedule E in your offer because most owner's are
reluctant to provide it unless it's been made part of the offer.
Okay,
now re-create your real estate analysis using the data you discover at
odds with your original number crunching, and there you have it. |
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