How do you calculate IRR on a rental property?

Question

Do you assume that you will sell the property after owning it for certain number of years?

Let's say you buy a property with initial cash investment of $50,000 and annual cash flow is $10,000. Now you have no plans to sell the property in the near future. How do you calculate the IRR on this one?

Bill Gulley · Answer

Good morning, Sharad, you can look at the blog by J. Scott that Jason provided above, and you will see that Scott mentioned that there are disadvantages of attemptng the calculation.

Your software programs, any program (as everyone knows I'm technolically deficient lol) will boil down to garbage-in, garbage-out.

The IRR is a budgetary tool to evaluate the return of a project compared to an alternative project or investment. It is not appropriate to look at one project. What you need is  the ROI or commonly computed by RE invetors is the cash on cash analysis.

To accurately compute the IRR, you need the cost of money based on alternative sources as well as an economic venture into the opportunity costs of various investments or cash flows. By definition, you are bringing the income back to a net present value to zero compared to an alterantive investment and the positive rate is the investment to be selected or at a the highest rate. Also called a manager's rate of return.

I have commented on this before on BP.
What you will get as an IRR will not be accurate from a either a financial or economic perspective without a solid captialization rate.

What many investors call the IRR is actually the ROI or cash on cash assumptions as the 20% mentioned above.

Financial ratios must be applied to appropriate circumstances, as the IRR/ERR, ROI, COC, Yield on investment, etc. are not all encompassing. Asset and liabilty rations, buget and income ratios or performance ratios must be used within the "family" for the appropriate analysis.

Vikram C. · Answer

In response to your question, it is important to note, as Buffett is fond of saying, that it is better to be approximately right than precisely wrong.  In your example, you are getting a return of 20% if there is no change in capital values and the cash flow is stable.  To that, you may wish to assume a little something if you expect inflation to increase your property value.

The problem with the IRR for a long-term investment is that the number you get is based on your long-term projections of cash flows and eventual resale price.  These projections are very unlikely to be accurate regardless of how good your perspective is, so you get a nice and neat IRR number which is, essentially, worthless.

Having said all that, if you wish to calculate the IRR, you can either assume an eventual resale and plug it into the cash flow series, or, if you think you will hold the property in perpetuity, you can just assume a series of cash flows based on your life expectancy or even beyond.  Due to the power of discounting, you will find that beyond a point, it does not matter what happens to values and the IRR is going to be about the same in either case.  (Cash very far in the future is worth very little today.)

J Scott · Answer

Check this out:

http://www.biggerpockets.com/renewsblog/2010/09/02/introduction-to-internal-rate-of-return-irr/

Mitch Kronowit · Answer

A perpetuity already factors in the time value of money. Your cash into a real estate purchase can be said to be your present value (PV) and your annual payments (A) are your total cash-flow. Divide A by PV and you have your rate or yield from this investment.

The tricky part (where the garbage in-garbage out principal comes into play) is figuring out what your cash-flows will be in the future - they will change, hopefully in a positive manner. There are also other factors to your total return, such as the principal reduction in your mortgage from making your monthly payments with rent money and whatever tax benefits you may enjoy.

Bryan Hancock · Answer

Great answers already....The comment about being precisely wrong is spot-on too!  I don't really have a whole lot to add to what was said above.  If you hold the property a long time the analysis is going to be imprecise.

MIRR allows you to vary your cost of capital for your situation if that is desirable.

Jeff S. · Answer

Assuming you have the actual income and expense schedule, the easiest way is to use the XIRR function in Excel.  XIRR returns the internal rate of return for a series of non-periodic cash flows.

This function requires two columns.  The first column contains each income or expense value (positive or negative as appropriate).   The second column contains the date associated with each value.  Following the XIRR syntax, enter  =XIRR(values, date) where the value and date arguments are designated by their cells,  and youâ€™ll obtain the IRR.  This is the most accurate calculation of return in my opinion because it considers the time value of money down to the day.

Alternately, you could simply calculate your ROI as 10000/50000=20% which is nowhere near as accurate but will put you in the ballpark.

Jeff

Sharad M. · Answer

Some really, really good points there. Thanks!

Sharad M. · Answer

I really appreciate all your replies.

Vikram, this is exactly what I wanted to confirm. I was basically looking to calculate IRR on a perpetuity and I got to the same result where beyond a time period it didn't matter and my IRR didn't change.

How do you calculate IRR on a rental property?

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