The internal rate of return on an investment property is an estimation of the value that the investment property generates during the time frame in which an investor owns it.
Real estate investors think of the internal rate of return on an investment property as the rate of growth that the investment can potentially generate. Essentially, the IRR is the percentage of interest that a real estate investor earns on each dollar he/she invests in a property over the entire holding period.
How to Calculate the Internal Rate of Return on an Investment Property
The internal rate of return on an investment property is associated with another real estate investment term – the net present value (NPV) – which is the sum of the present value of incoming cash flows minus the outgoing cash flows over a period of time.
You can find real estate IRR mathematically by setting the net present value (NPV) equation equal to zero (0) and then solving for the rate of return. The equation to calculate IRR is as follows:
NPV = ∑_(n=0)^N (Cn /(1+r)^n) = 0
N: The total number of years
Cn: The cash flow in the current period
n: The current period at that step in the formula
r: The internal rate of return
Advantages of Using the Internal Rate of Return on an Investment Property
1. Time Value of Money
The most important advantage of internal rate of return on an investment property as a metric of return on investment is that it uses cash flow and considers the time value of money in evaluating an investment property. This is a bit lacking in the average methods like the return on investment (ROI).
Based on the formula above, you can see that the internal rate of return is measured by calculating the interest rate at which the present value of future cash flows equals the required capital investment. The advantage is that the timing of cash flows in all future years is considered and, therefore, each cash flow is given equal weight by using the time value of money.
Moreover, since the IRR looks beyond the property’s net operating income (NOI) and its purchase price (which is used in calculating the cap rate), you will get a clearer picture of the type of returns which the investment will generate from beginning to end, which is something average real estate return on investment metrics don’t offer. This is extremely helpful for you if you want to become an expert real estate investor and are planning to invest in real estate for a long period of time.
Another advantage of the IRR method is that it is very clear and easy to calculate in order to compare the worth of different investment opportunities. It is a single percent figure that takes into account multiple factors such as incoming cash flows and outgoing cash flows as well as financing costs and appreciation.
Assuming that all investment properties require the same amount of up-front investment, the property with the highest IRR (provides the highest cash flow) would be considered the best. In theory, real estate investors should undertake all investments available with IRRs that exceed the cost of capital. In other words, you can consider an investment acceptable if its internal rate of return is greater than the minimum acceptable rate of return or cost of capital.
The real estate internal rate of return on an investment property is also beneficial for budgeting purposes. For example, it is useful to provide a quick overview of the potential value of purchasing new equipment as opposed to repairing old equipment.
3. Hurdle Rate Not Required
The hurdle rate is basically the required rate of return at which real estate investors agree to fund an investment. This rate is a difficult and subjective figure and typically ends up as a rough estimate.
However, the hurdle rate is not required when estimating the internal rate of return on an investment property. Real estate IRR is not dependent on the hurdle rate, which mitigates the risk of a wrong determination of the hurdle rate. You can simply select the best investment properties once the IRR is calculated.
After understanding the advantages of IRR, you can see why the internal rate of return on an investment property is important in real estate. The internal rate of return on an investment property is an indicator of the efficiency, quality, or yield of the investment. But still, there are disadvantages to relying on IRR to compare real estate investments, and we can’t conclude without mentioning them.
Disadvantages of Using the Internal Rate of Return on an Investment Property
- The internal rate of return on an investment property requires a large number of assumptions about future events, such as how the overall housing market is going to perform and the amount of cash flow that will be generated, which may or may not end up being true.
- Real estate IRR fails to compare investments of different lengths. For example, an investment of a short duration may have a high IRR, making it appear to be the best real estate investment, but it may also have a low NPV. On the other hand, an investment with a longer timeframe may have a low IRR but may add a large amount of value to the investment over time. Therefore, when calculating the internal rate of return on an investment property, it’s best to use it in evaluating investment opportunities with a similar level of risk and holding period to avoid making the wrong investment decision.
- It ignores future costs, therefore, your calculations of the internal rate of return on an investment property can become useless if any unexpected costs arise or if you can’t sustain the type of rental income you had in mind at the start of the investment.
- Real estate investors can often become lazy and simply just rely on the IRR percentage without taking into consideration the assumptions used in the calculation. As a result, it may end up oversimplifying what could be a complex investment.
When evaluating potential investments opportunities, the internal rate of return, or IRR, is an important metric in determining which investment is most worth pursuing. The internal rate of return on an investment property is important in real estate because it measures the rate of return of anticipated cash flows generated by the investment, allowing real estate investor to compare the IRR for each property under consideration to come to a final investment decision. Remember that the higher the internal rate of return on an investment property, the more desirable it is to invest in.
IRR shouldn’t be the only figure to rely on when looking to invest in real estate. So, whether you’re a new investor ready to dive into the real estate business or an experienced investor looking to expand your portfolio, Mashvisor can provide you with different real estate tools to guide you into the best real estate investment world.