Every real estate investor knows that it is important to calculate the rate of return on investment properties to estimate expected profits. Despite the fact that the return on investment calculator (ROI) can do just that for a fixed point of time, the internal rate of return calculator (IRR) is a real estate metric that measures investment properties’ long-term yield and provides results more accurately than the ROI calculator.
What Is the Internal Rate of Return?
The internal rate of return (IRR) in real estate investing estimates the value an investment property generates during the entire time frame in which a real estate investor owns it (holding period). Real estate investors also think of the IRR as the rate of growth an investment property can potentially generate.
The internal rate of return is also another term used for interest. So, essentially, the IRR on investment is the percentage of interest which a real estate investor receives on each dollar he/she invests in an investment property throughout the entire holding period.
The internal rate of return calculator is a comprehensive way to estimate the profitability of real estate investments. It looks beyond the investment property’s net operating income (NOI) and its purchase price, which means you will get a clearer picture of what type of returns the investment will generate from beginning to end – and that is something average return on investment metrics don’t offer. This is extremely helpful for real estate investors planning to invest in the real estate business in the long term.
Another advantage of the internal rate of return calculator is that it offers real estate investors with the means to compare different investment properties based on their return. For example, suppose a real estate investor is interested in two rental properties for sale. Both have the same offer price and same expected rent. However, one has higher renovation costs, while the other has higher property tax. How can you, as a real estate investor, determine which property is the better investment? You can make this decision using an internal rate of return calculator. The investment property with the higher IRR would be considered the better.
Internal Rate of Return Calculator – Approaches
To help clarify these approaches, we’ll use the same following data set: suppose that you, as a real estate investor, purchased a $50,000 investment property. You gained a cash flow of $10,000 in year 1, $20,000 in year 2, and $30,000 in year 3.
1. Internal Rate of Return Calculator: Trial and Error
The formula for the internal rate of return calculator is a rather complicated one. Unlike the return on investment (ROI) metrics, the internal rate of return is linked to another component – the net present value (NPV). The NPV is the sum of incoming cash flow minus outgoing cash flow over a certain time period. Now, to estimate the internal rate of return mathematically, you have to set the net present value to zero (0) and then solve for IRR in the following formula:
NVP = -CF + CF1/(1 + IRR) + … + CFn/(1+ IRR)^n = 0
- NVP: Net present value
- -CF: Outgoing cash flow
- CF: Cash flow at the present moment at that step of the formula
- n: Current period at that point of the formula
- IRR: Internal rate of return
Referring to the scenario mentioned above, the formula would look like:
NPV = -50,000 + 10,000/(1+IRR) 1 + 20,000/(1+IRR) 2 + 30,000/(1+IRR) 3 = 0
As you can imagine, the internal rate of return calculator can be a tiresome process if done by hand because, through trial and error, you have to keep trying until you find the value of IRR on investment that makes the NPV equal to zero.
Fortunately, there are a number of software programs that real estate investors use as an internal rate of return calculator, mainly financial calculators and Microsoft Excel.
2. Internal Rate of Return Calculator: Using a Financial Calculator
Step 1: Enter the outgoing cash flow value of the initial investment into the calculator’s cash flow register.
To open the cash flow register, press the Cash Flow [CF] key. The calculator should read [CF0=], which tells you to enter the cash flow for year 0. Because you need to pay $50,000 (outgoing cash flow) to make the initial investment, this value has to be negative. Thus, type in -50,000 for CF0, and hit the [ENTER] key.
Step 2: Enter the incoming cash flow values of the subsequent years.
After typing in the outgoing cash flow value, hit the down arrow once. The calculator should read [CF1=], which tells you to type in the amount for the first incoming cash flow, 10,000. After you hit [ENTER], the calculator should say [CF1=10,000].
To continue, enter the cash flow value of year 2 by hitting the down arrow twice. The calculator should read [CF2=]. Type in the incoming cash flow of the second year, 20,000, and hit [Enter]. The calculator should say [CF2=20,000]. Do the same thing for the third period and, once again, hit the down arrow twice.
Step 3: Calculate the internal rate of return.
Once the incoming cash flow values have been entered into the calculator, press the [IRR] key. The calculator should read [IRR=0.000].
Press the [CPT] key (at the top left corner of the calculator) to display the internal rate of return for the data set. If you’ve followed this process accurately, the calculator will display the correct internal rate of return on investment, which for our example is 8.208%.
3. Internal Rate of Return Calculator: Using Microsoft Excel
Finding the internal rate of return using Microsoft Excel is fairly straightforward.
Step 1: Type the initial amount of the investment property (outgoing cash flow) into any cell on the spreadsheet. Keep in mind that exactly as when using the financial calculator, this initial value must be a negative number. Thus, for our original example, type -50,000 into the A1 cell of the spreadsheet.
Step 2: Type the subsequent incoming cash flow values for each year into the cells directly under the outgoing cash flow amount. This means type 10,000 into cell A2, 20,000 into cell A3, and 30,000 into cell A4.
Step 3: Calculate the internal rate of return by typing in the function command “= IRR (A1: A4)” into the cell directly under all the values (A5 for our example) and hit the enter key. In that cell, the internal rate of return value should be displayed – which for our example is 8.2%.
The internal rate of return is an important number to calculate that some real estate investors neglect. The internal rate of return calculator gives real estate investors a clearer picture of what type of returns the investment will generate from its beginning to its end, which is something other metrics don’t offer.
There are a number of approaches to an internal rate of return calculator. You can calculate IRR through trial and error – where you have to use the net present value (NPV) formula, with a financial calculator, or by using Microsoft Excel.
Mashvisor’s investment property calculator computes and predicts numerous rate of return metrics like the cash flow, the cap rate, and the cash on cash return, and provides the most accurate results possible. Moreover, it indicates whether or not a property is a good investment opportunity based on the rate of return on investment results provided for the user.
Find out more about Mashvisor’s investment property calculator and how it estimates the rate of return here!
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