Rei acronym IRR? Internal rate return

[Matt R.]

newbie question

What is IRR?

How is it calculated? Do you guys use it?

Matt

[Rick Baggenstoss]

I had to do IRR and NPV a bit in grad school. I think it's more important to know how to use and interpret vs. calculate it. Calculators/spreadsheets can calculate.

Here's my overly simplified explanation. NPV is a go/no-go decision tool. When NPV is positive, then you should theoretically be ok to move forward with a project.

NPV should consider the income and expense streams and be discounted or adjusted by a risk factor or required rate of return given the nature of the project. For example, a property in Detroit with the same ROI and cash flows should not be considered the same risk as a Note on a home in NYC. You might, for example, discount Detroit at 15% (required rate of return) vs. 8% in NYC.

IRR is useful for complex irregular cash flows over a significant period of time. If all the investment and income is made in year 1, then it's of no use. For a commercial property with payments/income years away, you would want to calculate your ROI as IRR (considering when expenses and income occurred). The adjustment factor considers the time value of money or cost of money, e.g. 6% interest rate on a loan. Risk is not considered in this calc.

I would argue NPV should be use a lot for residential analysis with a "portfolio" of risks to optimize returns so not all investments are in Detroit, nor are they all low margin, bread-and-butter investments either.

Rick