IRR and NPV

[Scott Jones]

I'm new to the site and have been able to read through a lot of discussions and articles written which I feel give good advice about analyzing deals. I love seeing others lend advice to newer investors. I see the 2% and 50% rule mentioned all over which is a good general rule to follow but by no means the end all be all. I have yet to read anything about informing new investors about IRR and NPV. In my business these numbers are the cornerstone to any deal I'm looking at. Each property is different in that I can accept a smaller or larger IRR depending on the overall risk entailed with the property, but none the less is still a main driver. Since REI (buy and hold) can be a long term investment for many (5,10,15+ years) I believe it's imperative that you factor in time value of money into any analysis. Understanding how NPV works is crucialI and I feel it should be a large factor if you move forward with a deal or not. Again the deal should be thoroughly analyzed for cost and risk factors but can really help you decide the price you should pay today for the cash stream.

My style of investing is focused on a balance between cash flow and debt repayment. I keep adequate cash reserves and really try to have my renters pay down much of the debt. I don't do 30 yr mortgages as the less interest I have to pay a bank is more cash in my pocket on the sale. Cash flow is great, but just one part of the overall equation in the deal when bringing a lender into the deal.  Just my thoughts and everyone has a different style but I'm surprised I dont hear more about these two important numbers that should be factored in. As anyone else wondered this?

[Frank Jiang]

IRR is one of the most important metrics you can find for any investment vehicle. I personally believe that IRR is a far superior metric compared to commonly used real estate metrics like cash flow, CAP rate, and cash on cash. IRR is far superior in its ability to account for leverage and the motions you have to go through to calculate it force you to have a deeper understanding of how the the money flows through a property.

However, the biggest problem with IRR when looking at Real Estate is that so much of the estimated return is based on your exit valuation, which depending on what sort of real estate you are involved in, can be absurdly difficult to calculate.

The important thing isn't to decide which metric is better than others, it's the ability to separate out your revenue, expenses and cashflow to see where all money goes.  How much of your cashflow pays principal vs interest?  How much equity will you have when you exit your investment in 10 years?  If you can answer these kind of questions, it really doesn't matter what metric you use to determine profitability.

Also, I personally don't see any point in calculating NPV. IRR tells you everything NPV tells you for a quarter of the work.