The internal rate of return (IRR) is one of the most commonly used rate of return measures during a real estate analysis for good reason: the time value aspect of money associated with the internal rate of return considers That the timing of the investment property receipts can be as important as the amount received.

Unlike other popular returns used by investors to analyze the performance and profitability of rental income properties that do not take into account the value of money over time, such as the capitalization rate and cash over cash, the IRR if it does.

As a result, the internal rate of return is generally more popular than other rates of return for a real estate investor because it calculates the value of money over time and provides a link between the present value (PV) and the future (FV) of any stream of benefits.

The idea is simple.

Because a dollar in hand today is preferable to one a year or five from now, real estate investors want to take into account both the timing and scale of the cash flows generated by the income-generating property in determining what the rental income stream. worth it today. The internal rate of return reveals the rate at which future cash flows must be discounted to exactly equal the amount of investment.

How IRR works

The internal rate of return reveals in mathematical terms what a real estate investor’s initial cash investment will produce based on an expected flow of future cash flows discounted to equal today’s dollars, not tomorrow’s dollars.

Consider this.

When you make a real estate investment, you are investing cash to receive a series of future annual cash flows resulting from rental income plus an orderly profit when you sell the property.

The challenge for real estate investors, then, is to figure out what rate of return the investor’s initial capital will get based on those periodic future cash flows while also considering the number of time periods (years) considered in the holding period. .

The internal rate of return model responds to that challenge by creating a single discount rate whereby all future cash flows can be discounted until they equal the investor’s initial investment.

How to calculate

Calculating IRR manually is not practical because the calculation involves tedious and time-consuming mathematical solutions. Even the most skilled real estate investment specialist will typically use a financial calculator or real estate investment software program to calculate it.

So we’ll ignore the formula (you can find it online if you’re really interested in knowing it) and consider what it means instead.

Let’s say you have $ 100,000 to invest in a rental income property and you plan to keep it for five years. During those years, you plan to receive five annual cash flows and then an additional amount from the sale of the property (also known as a reversal). When you find the single rate of return that discounts the sum of all those future cash flows until it equals your initial investment, you have the internal rate of return.

In other words, what your cash investment will produce for those cash flow projections based on the current value of the dollar, or as if those cash flows were collected today and not in the future.

Of course, no single element of a real estate analysis should determine an investment decision to the exclusion of other factors and measurements. But the internal rate of return can help guide your purchase decision, so plan to use it.

One final thought. If you are serious about real estate investing, it is highly recommended that you invest in a real estate investment software solution. In this case, you will not only get a wide range of essential returns including IRR, but you will also benefit from all the real estate analysis features provided by quality investment software.