What does IRR (internal rate of return) mean in real estate?
One of the metrics used in real estate investments is the internal rate of return, or IRR, which is used to analyze how profitable a potential investment can be. It is a way to compare the future value of an investment based on the value of today's dollars. IRR is done by calculating what an investment is worth today and what it will be in the future, then comparing the amount of the investment so that you can determine the risk of the investment. It is one of the many metrics that is used by real estate investors when they are evaluating if a potential investment is worthwhile to them or if it is too risky. In this article, we will break down everything you need to know about IRR when investing in real estate.
How is IRR calculated in real estate?
Calculating IRR is not easy, but according to Investopedia, this is the formula for calculating IRR:
How to Calculate IRR:
Using the formula, one would set NPV equal to zero and solve for the discount rate, which is the IRR.
The initial investment is always negative because it represents an outflow.
Each subsequent cash flow could be positive or negative, depending on the estimates of what the project delivers or requires as a capital injection in the future.
However, because of the nature of the formula, IRR cannot be easily calculated analytically and instead must be calculated iteratively through trial and error or by using software programmed to calculate IRR.
We know it is a complex formula that takes a math whiz to solve fully, which is why we have an IRR calculator here to figure everything out for you.
Example of an IRR Calculation
Now that we have given you the complex, and probably confusing math problem, let's look at an example to make it a little easier to understand. Here is a simple example from Investopedia:
Assume a company is reviewing two projects. Management must decide whether to move forward with one, both, or neither. Its cost of capital is 10%. The cash flow patterns for each are as follows:
Project A:
- Initial Outlay = $5,000
- Year one = $1,700
- Year two = $1,900
- Year three = $1,600
- Year four = $1,500
- Year five = $700
Project B:
- Initial Outlay = $2,000
- Year one = $400
- Year two = $700
- Year three = $500
- Year four = $400
- Year five = $300
The company must calculate the IRR for each project. Initial outlay (period = 0) will be negative. Solving for IRR is an iterative process using the following equation:
$0 = Σ CFt ÷ (1 + IRR)t
where:
- CF = net cash flow
- IRR = internal rate of return
- t = period (from 0 to last period)
or:
- $0 = (initial outlay * −1) + CF1 ÷ (1 + IRR)1 + CF2 ÷ (1 + IRR)2 + ... + CFX ÷ (1 + IRR)X
Using the above examples, the company can calculate IRR for each project as:
IRR Project A:
$0 = (−$5,000) + $1,700 ÷ (1 + IRR)1 + $1,900 ÷ (1 + IRR)2 + $1,600 ÷ (1 + IRR)3 + $1,500 ÷ (1 + IRR)4 + $700 ÷ (1 + IRR)5
IRR Project A = 16.61 %
IRR Project B:
$0 = (−$2,000) + $400 ÷ (1 + IRR)1 + $700 ÷ (1 + IRR)2 + $500 ÷ (1 + IRR)3 + $400 ÷ (1 + IRR)4 + $300 ÷ (1 + IRR)5
IRR Project B = 5.23 %
Given that the company's cost of capital is 10%, management should proceed with Project A and reject Project B.
Why IRR is Important for Real Estate Investments
The reason that IRR is important for real estate investments is that it is one of the metrics to help you calculate how profitable an investment is. Investing in real estate is not publicly tracked and traded like stocks and bonds are, so it is not as easy to figure out if something is worth investing in as it is with stocks and bonds. Since real estate is a privately owned asset, there are many more variables in play as to whether or not an investment is a good idea. IRR is great for helping you predict whether or not you will have good return rates for investments in the future, so you can better determine if you want to invest in a property.
Drawbacks from Using the IRR Formula
There are a few drawbacks to depending on the IRR formula alone, which is why we recommend using multiple metrics when deciding on investments.
Some of the disadvantages to the IRR are:
- The initial investment amount is not considered.
- It does not compare holding periods.
- When looking at comparable investments, it ignores the dollar value.
- There is no consideration for reinvesting positive cash flows.
- IRR does not account for removing negative cash flows.
Internal Rate of Return Calculator
This internal rate of return calculator (or the IRR calculator for short) is a helpful tool for visualize whether a future investment will be profitable for you.
What is a good IRR for real estate?
As is the case with other metrics when comparing investments, whether an IRR is good or bad is subjective, depending on your goals. Generally, a higher IRR is better than having a lower one, but sometimes a bigger IRR means the project is riskier than one with a lower IRR. As always, it boils down to how much risk you as the investor are willing to have in your portfolio. If everything is completely equal risk-wise, it is usually better to choose a higher IRR.
IRR for Vacation Rentals
If your main goal for investing in a vacation rental is to generate a profit and recoup your original investment, you want to have a positive IRR. However, it is more guesswork to calculate the IRR for a vacation rental because there are more what ifs in play with a vacation rental than there are with a rental home. A vacation home can be a lucrative investment, though, especially if you promote it on a platform that gets a lot of foot traffic.
Conclusion
When investing, it is important to understand how your money will work for you. You need to have an idea of your risk level before you begin investing in real estate, as well as have an idea of how long you are willing to wait to get your return on investment. The IRR is one of the many metrics available to help you decide if a property is worth investing in.
Be sure to check out our other guides on important investment metrics such as a property's cash-on-cash returns and cap rate as well.