What is IRR (internal rate of return)?

In real estate, there are many ways to measure a property’s return. For example, return on investment (ROI) offers a simple calculation to figure out how much money an investment will generate: net profit divided by the cost of the investment.

However, you can also measure profitability with the internal rate of return (IRR), a metric that accounts for the growth of an investment over time.

IRR basics

Internal rate of return measures the average annual return you can expect from an investment over its lifetime, accounting for when money comes in and goes out.

For example, a 15% IRR means the investment is expected to grow at an average rate of 15% per year. However, this calculation recognizes that receiving $1,000 today, for instance, is more valuable than receiving $1,000 5 years from now – because money received earlier can be reinvested to generate additional returns.

Understanding how IRR is used

Investors use IRR to estimate a prospective investment’s return rate and compare it against other potential investments. The higher the IRR, the better the investment.

For example, if buying a new rental property promises a 16% IRR and renovating an existing property in your portfolio promises a 22% IRR, the latter may be a better use of your capital.

Here are some different ways you can use IRR:

• Investment analysis: IRR can help you evaluate and compare the profitability of different projects.
• Project feasibility: Assess the feasibility of a project based on whether the expected IRR justifies the risk and capital.
• Capital budgeting: IRR can help you know where to deploy capital, prioritizing projects with the highest potential return.
• Cost of capital comparison: Compare an investment’s IRR to the cost of financing the deal to determine whether it’s worthwhile.

An example of applying IRR

In real estate investing, IRR is a powerful tool for determining the profitability of a deal and how it compares to other potential investments.

A typical real estate investment may have multiple cash inflows and outflows. For example, you might spend $100,000 on a rental property, receive $1,000 in annual cash flow for the first 5 years, and then $1,100 in annual cash flow for the next 5 years.

IRR can give you a comprehensive view of this project’s profitability by giving you an annual return percentage that accounts for how much money goes in and out of your pocket and when.

What’s a good IRR?

Whether an IRR is good or bad is subjective. It depends on the cost of financing the deal (for example, mortgage rates and closing costs) and the opportunity cost of not investing the capital elsewhere (like in another real estate deal).

All else equal, a higher IRR is always better. Keep in mind, however, that IRR doesn’t account for how much risk and effort an investment will require. The riskier and more time-consuming an investment, the more you should discount its projected IRR.

What is the IRR formula?

The IRR calculation uses three key inputs: initial investment cost (your upfront outlay), net cash inflows (money coming in after subtracting money going out in each period), and net present value (the current dollar value of future cash flows). IRR is found by determining which rate makes the net present value equal zero.

Here’s the formula:

0 = NPV = ∑ (Ct  ? (1 + IRR)t) − C0

Where:

• NPV = net present value
• Ct= net cash inflow during the period t
• C0= total initial investment costs
• t = number of time periods
• IRR = internal rate of return

Calculating IRR in Excel

While you can calculate IRR manually, it’s not practical since it can’t be solved algebraically but requires a lot of trial and error.

Fortunately, calculating IRR in Microsoft Excel (or Google Sheets) is much easier. The “=IRR” and “=XIRR” functions let you enter an investment’s various cash flows (and dates if cash flow intervals are inconsistent) to determine the IRR automatically. Here are the steps:

1. List the investment’s cash flows in separate cells.
2. Enter the =IRR or =XIRR formula in a new cell.
3. Highlight the cash flow cells to include as “values.”

What are the limits of IRR?

Despite its many uses, IRR isn’t without limitations. To build a real estate portfolio, you must evaluate investments with a variety of metrics. Here’s where IRR falls short:

• Potential for multiple IRRs: If an investment’s cash flows are non-conventional (meaning they change signs from negative to positive or vice versa more than once), the IRR formula can yield multiple solutions, making it hard to know which is correct.
• Reinvestment assumption: IRR assumes that all cash flows generated by the investment are reinvested at the same rate as the IRR. However, this is unrealistic, and actual returns may differ as a result.
• No measure of size: IRR doesn’t account for the size of an investment’s returns. For example, a smaller project may have a higher IRR than a larger one, but the larger project may still generate more in total dollar value.

IRR example

To illustrate the use of IRR, consider the cash flow patterns of the following two investments:

Both investments have an investment period of 5 years and involve an exit sale in year 5.

To calculate each project’s IRR, enter the cash flows into the IRR formula in Excel. For Investment A, this yields a 10% IRR. For investment B, this yields a 14% IRR.

Assuming your cost of capital is 12%, you should pursue investment B and reject investment A.

IRR vs. compound annual growth rate (CAGR)

IRR and compound annual growth rate (CAGR) both measure the compounded annual return of an investment expressed in a percentage. However, CAGR uses only an investment’s beginning and ending values over a certain period and is easier to calculate, while IRR considers multiple cash flows and periods and is harder to calculate (at least by hand).

IRR vs. return on investment (ROI)

IRR and return on investment (ROI) both measure an investment’s performance expressed in a percentage. However, ROI shows an investment’s total growth from start to finish, while IRR shows an investment’s annualized return. Consequently, the two numbers will be roughly the same for investments that last one year but different for longer periods. In addition, unlike IRR, ROI is a simple calculation: ROI = net return / cost of investment.

The bottom line: Understand the meaning of IRR

IRR is a powerful metric for measuring the average annual return of an investment while accounting for the timing of cash flows. While it can help you compare investment opportunities and make more informed decisions about how to allocate your capital, it should be used alongside other metrics like ROI and CAGR for a fuller picture.

Ready to explore your next real estate investment opportunity? Take the first step by applying for a mortgage.

This article is for informational purposes only and is not intended to provide financial, investment, or tax advice. You should consult a qualified financial or tax professional before making decisions regarding your retirement funds or mortgage.

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