Real estate investors are always looking for the best real estate investments and new ways to make money from real estate. It is not a secret that in order to be successful and make money from real estate, realtors need to have good knowledge in the field. Today, we will discuss one more real estate metric useful for finding and managing the best real estate investments. Investors usually have extensive knowledge about return on investment. However, how much do you know about the internal rate of return in real estate investing? It sounds almost the same, doesn’t it? Then, you may ask: “What’s the difference between return on investment and internal rate of return?” Other questions that stay are: “Why do real estate investors need to use internal rate of return? How to calculate internal rate of return? What is good internal rate of return?” You can find the answers to all these questions and much more useful information below.
Return on Investment (ROI) vs. Internal Rate of Return (IRR)
Return on investment is a real estate metric which measures the efficiency of an investment property. ROI calculates the return (the gain from the property minus the costs) divided by the costs of the real estate property. It shows the return as a percentage. Return on investment expresses the total growth of the investment property, but it ignores the “time value of money”. Moreover, it is only usable when comparing real estate investments over equal time frames. This, however, is not the case with internal rate of return.
Internal Rate of Return
Rate of return characterizes the profit or loss an investment is making over a specific period of time. In general, rate of return presents a percentage of the investment’s costs. Rate of return is a widely used real estate metric. When we talk about internal rate of return, though, we talk about the rate earned as percentage on each dollar that has been invested in the property. Additionally, internal rate of return takes in consideration the “time value of money” as the rate is calculated for each period of the real estate investment. IRR is important as it gives real estate investors the opportunity to monitor the growth of their money annually. Most importantly, internal rate of return is very useful when comparing real estate investments with different time frames.
How to Calculate Internal Rate of Return?
So far we reviewed what internal rate of return actually is. Now it is time to answer the question: “How to calculate internal rate of return?” In all fairness, this is not a simple task. The formula for calculating internal rate of return is a rather complicated one. Before moving to the formula, let’s discuss one of its main components, namely, the net present value. The net present value is the sum of the current value of the incoming cash flow minus the outgoing cash flow over a certain time span. Mathematically speaking, it is necessary to set the net present value to 0 in order to compute IRR. The internal rate of return formula goes as follows:
NVP= ∑ _ (n=0) ^N (CF/ (1+IRR) ^n) = 0
Here is the meaning behind the different abbreviations in this internal rate of return formula:
- NVP: Net Present Value
- CF: Cash Flow at the present moment at that step of the formula
- n: The current period at that point of the formula
- IRR: Internal rate of return
Another way to write the IRR formula is:
0= -CF + CF1 / (1 +IRR) +…+ CFn / (1+ IRR) ^ n
The equation is set to 0, because that is the NVP value. The initial cash flow value is assigned with a minus because that is the cost of the investment. The n value represents each yearly calculation of IRR.
Tools for Calculating IRR
As you can imagine, it is extremely difficult to calculate the internal rate of return by hand. Luckily, there are various softwares and programs which can help you in solving this problem. For instance, there is a simple Excel formula for calculating IRR. The investment property calculator is another tool which offers this option. Nevertheless, the results presented by the investment property calculator usually deviate from the ones presented in Excel, for example. Thus, it is advisable to use a specified program for computing IRR and use the investment property calculator for other real estate metrics such as cap rate, cash flow, cash on cash return, etc.
Even though, calculating IRR is difficult, it is a sure way to help you make money from real estate. This is due to the fact that internal rate of return gives the real estate investor the chance to compare different investments, not only according to their time span. Realtors can compare various property types based on their IRR. Additionally, the analysis provides a clear picture of the potential return the investment property will generate not only from start to end, but within specific time frames as well.
What Is Good Internal Rate of Return?
It is logical to ask yourself: “What is good internal rate of return?” Well, initially, good internal rate of return is when the value of IRR is higher than the original investment. Of course, the higher the value of the internal rate of return, the better. In relation to this, IRR can be used as a tool for finding the best real estate investments. Comparison of the IRRs of different properties allows this. Of course, the good IRR depends on many factors affected by the real estate investor, such as financing method, property management, etc.
Are you willing to be successful in your real estate investing business? Keep reading on Mashvisor for many useful tips and insightful information on numerous real estate topics.