The Internal Rate of Return (IRR)

The Internal Rate of Return (or IRR) is generally one of the more popular rates of return amongst real estate investors because it accounts for "time value of money".

In other words, unlike many returns associated with real estate investing, IRR surrounds the principal assumption that a dollar in hand today is preferable to a dollar at the end of some future year.

As a result, the internal rate of return helps investors determine both the timing and the scale of future cash flows generated by an income-producing property by revealing what those future cash flows are really worth to the investor in today's dollars.

The idea is straightforward. Given that the investor is making an investment with money that has a particular buying power today, it's prudent for him or her to make their investment decision based upon what a property's future income benefits are also worth today.

It's beyond the scope of this article to discuss the concept of time value of money in detail, but allow me to briefly explain how it relates for our purpose.

Future values are discounted at some rate to determine present values. The rate might be the inflation rate. For instance, if you plan to collect some amount of money in one year and expect the annual inflation rate to be 2.7%, you would discount your future earning by 2.7% to compute its present worth.

In this case, however, real estate investor's already know that the initial cash required to purchase the property is the present value. What they want to know is how much of a yield they can expect on their investment by uncovering the rate at which all future cash flows must be discounted to exactly equal that initial cash amount. That discount rate will signify their yield.

Formulation

Let's consider an example.

Say you're about to invest $100,000 cash for a rental income property and expect to collect $10,000 per year over the next five years. You also feel that you will collect an additional $140,000 in sales proceeds due to a sale in the fifth year. You want to know the internal rate of return because it will tell you how much of a return (yield) you can expect on your initial cash investment of $100,000.

The result and explanation are illustrated below.

How to Compute

Internal rate of return is not a computation that you can make in head. It will require a third-party calculator, spreadsheet, or other calculation solution. Here are three suggestions.

1. HP12. A hand-held financial calculator. In this case just open the instruction manual, read along and make the necessary keyboard selections.
2. MS Excel. Open the spreadsheet and select one column to enter the initial cash investment (make it a negative number), enter the five cash flows in concurrent fields below it with the sales proceeds added to the fifth, then select a separate field and use the IRR function to complete the calculation.
3. iCalculator. Forgive the shameless plug but I developed this suite of online real estate calculators to make calculations like IRR easy. Follow the link provided below to check it out for yourself.

Rule-of-Thumb

By itself the internal rate of return is not enough to sign on the dotted line. There are many other factors to consider like economic and market area trends, financing, structural condition and location, income tax implications, as well as a host of other prudent real estate investing due-diligence practices.

Moreover, one-size doesn't fit all. Whereas one investor might find some rate of return appealing, another might have no interest whatsoever. It depends on the investor's particular objective and how it might stack up to other investment opportunities available. But you get the idea.

So You Know

ProAPOD provides two real estate investing software solutions that compute Internal Rate of Return as well as a suite of online real estate calculators.

Here's to your real estate investing success.