As real estate investors, there’s no doubt that you’ve already heard about the return on investment (ROI). However, have you heard about the internal rate of return (IRR)?
It’s pretty well-known that in order to make money in real estate investing, property investors need to find investment properties with a high rate of ROI. This is why every real estate investor should calculate the return on investment before even buying an investment property. However, calculating the ROI of investment properties gives property investors an estimated figure of what they can expect to earn for a fixed point in time. Calculating the internal rate of return, on the other hand, does more than that!
So, how much do you know about the internal rate of return in real estate investing? If your knowledge on this topic is limited, keep reading as we break down the definition of the IRR, how to calculate it, and why it is important for property investors to be familiar with it.
Internal Rate of Return (IRR) Definition
To succeed as a real estate investor, not only do you need to be aware of how much money you would potentially make from your investment property, but you should also know when you would receive it. This is why a real estate investor should be familiar with the internal rate of return. In real estate investing, the internal rate of return is an estimate of the value that an investment property will generate during the time frame in which you own it. Property investors should think of the internal rate of return as “the rate of growth a project is expected to generate” – Investopedia. So, the internal rate of return is, essentially, the percentage of how much you’ll earn on each dollar you invest in a property over the entire holding period.
Internal Rate of Return Calculation
Mathematically speaking, property investors can find the internal rate of return by setting the Net Present Value (NPV) equation equal to zero. Here, property investors are introduced to yet another unfamiliar term which should be explained. The net present value is simply the sum of incoming cash flow minus outgoing cash flow over a certain period of time. Thus, the formula for calculating the IRR is:
- N: The total number of years
- Cn: The cash flow in the current period
- n: The current period
- r: The internal rate of return
It seems like a complicated equation, doesn’t it? It’s definitely not simple to calculate by hand as it requires trial and error until you find the value for IRR that makes the NPV equal to zero. Fortunately, for property investors, there are various software and programs (like the internal rate of return calculator) which can help in solving this problem!
Why Should Real Estate Investors Calculate the Internal Rate of Return?
The internal rate of return presents another comprehensive way to determine the profitability of an investment property. Moreover, the IRR looks beyond an investment property’s net operating income (NOI) and purchase price, giving the real estate investor a clearer picture of the returns he/she can expect from beginning to end. This is something the average return on investment metrics don’t provide.
In addition, probably the most important advantage of calculating the internal rate of return is that it takes both cash flow and the time value of money when evaluating investment properties. Ultimately, this gives a real estate investor the means to compare and rank alternative investments based on their yield rather than on their present value, thus, allowing him/her to identify the best investment for the long term.
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Keep in Mind…
While the internal rate of return is a good metric to estimate the profitability of investment properties, there are certain things to keep in mind before relying on it to compare real estate investments. First of all, it can be misleading if used alone. When calculating the IRR, property investors are required to assume a number of future events which may or may not happen. Basically, you’ll have to assume the amount of cash flow that investment properties will generate and how the overall market is going to perform – both of which are things you can’t be sure of.
In addition, in the real estate investing business, there is always a potential for unexpected costs and expenses to arise. If this happened, a real estate investor might not be able to sustain the rental income and cash flow he/she had assumed at the start of an investment. Consequently, your calculations of the internal rate of return will become useless if any unexpected costs arise!
Moreover, we all know the importance of performing a comparative market analysis to evaluate investment properties and find the best-performing ones. This is another thing that property investors can’t rely on the internal rate of return solely to perform. Since the IRR takes into account the time value of money, it can’t be used to compare investments of different lengths. As a result, it’s best to use the internal rate of return to only evaluate different investment opportunities with similar holding periods to avoid making investment decisions based on false results.
Essentially, you need additional tools to fully evaluate a potential investment property. Did you know that Mashvisor provides property investors with an investment property calculator? This is a real estate investing tool that allows you to calculate the different values related to an investment property, including the cash on cash return, cap rate, rental income, and occupancy rate. This helps property investors evaluate the profitability of investment properties and identify the best one. To learn how to use this real estate investing tool to make smart investment decisions, read this blog: Investment Property Calculator – A Simple Guide on Using it
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The Bottom Line
In the competitive real estate investing business, successful property investors are those who keep a close eye on their returns. The internal rate of return estimates the value of an investment over the entire holding period of the property. Knowing how to calculate the IRR will benefit you in your career as a real estate investor because it helps in comparing investment properties and determining which one is worth pursuing in the long term.
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