Have you heard of internal rate of return in real estate investing before? To turn a profit on investments, real estate investors need to know how to balance risks against potential rewards. Calculating the return on investment (ROI) of a real estate investment property can give you an estimated figure of what you can expect to earn for a fixed point in time. However, the internal rate of return in real estate investing (IRR) is an investment metrics more precise than the rental property ROI, used to measure investment properties’ longterm yield, and is a concept that real estate investors should be familiar with.
Internal Rate of Return (IRR) Definition
To become an expert real estate investor, not only should you be aware of how much money you would potentially obtain, but you should also know when you would potentially receive it. The internal rate of return in real estate investing is an estimate of the value that an investment property generates during the time frame in which you own it. Investors should think of the internal rate of return in real estate investing as the rate of growth a real estate investment can potentially generate. Essentially, the IRR is the percentage of interest you earn on each dollar you invest in a property over the entire holding period.
For example, suppose you purchased an investment property to rent out, and you plan to own the property for 10 years. You’d earn interest on the rental income you receive during the first year for the remaining nine years. Rental income received in the second year would earn interest for the next eight years, and so on, with each new year generating more interest. The overall interest earned over the full 10year period represents the IRR.
An Example of Internal Rate of Return
When you buy a rental property, the investment is made up of one outgoing cash flow (suppose you purchased the property with $123,400) followed by multiple incoming cash flows (regular rent payments). Suppose cash flow for years 1, 2, and 3 are $36,200, $54,800, and $48,100 respectively). In this scenario, the formula would look like:
NPV=123400 + 36200/(1+r)1 + 54800/(1+r)2 + 48100/(1+r)3 = 0
Solving the equation by hand requires trial and error until you find a value for r that makes the equation equal to zero. Fortunately, software programs like Excel provide a simple function for solving the equation which makes IRR calculations a piece of cake. Notice that when using a rental property ROI calculator, you’ll get different results.
You now may be asking “What is good IRR?”. In general, if the internal rate of return is greater than the initial investment, then it is considered a good IRR and it is a good idea to pursue the investment. Similarly, if the IRR is lower than the initial investment, then it may be best to reject it. Moreover, if you want to know what is good IRR, factors such as investment size, the holding period, and the incoming and outgoing cash flow need to be taken into consideration.
Calculating Internal Rate of Return on Investment
Now it is time to answer the question: How to calculate the internal rate of return? To be frank, this is not a simple task. The formula for calculating the internal rate of return is a rather complicated one. The internal rate of return in real estate investing is associated with another component – the net present value (NPV). The NPV is the sum of the value of incoming cash flow minus outgoing cash flow over a certain time period.
To estimate real estate IRR mathematically, set the net present value to zero (0) and then solve for IRR. The formula goes as follows:
NVP = CF + CF1/(1 +IRR) +…+ CFn/(1+ IRR)^n = 0
Where:
 NVP: Net present value
 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
For example, suppose you bought an investment property with $123,400, and the cash flow for years 1, 2, and 3 are $36,200, $54,800, and $48,100, respectively. In this scenario, the formula would look like:
NPV=123400 + 36200/(1+IRR) 1 + 54800/(1+IRR) 2 + 48100/(1+IRR) 3 = 0
Why Calculating Internal Rate of Return in Real Estate Investing Is Useful
1. Real estate IRR is a comprehensive way to estimate a real estate investment’s profitability. Since the IRR looks beyond the property’s net operating income (NOI) and its purchase price (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.
2. Simplicity: IRR is an easy metric to calculate; 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.
3. The internal rate of return in real estate investing gives real estate investors the means to compare alternative investments based on their return.
Limitations of Internal Rate of Return in Real Estate Investing
While the internal rate of return can tell you a lot about investment properties, there are disadvantages to relying on it to compare real estate investments.
1. The internal rate of return in real estate investing requires a large number of assumptions about future events which may or may not end up being true. You’re basically making assumptions about how the overall market is going to perform and the amount of cash flow that investment properties will generate, which are things you can’t be sure of.
2. 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 time frame may have a low IRR – earning returns slowly and steadily – but may add a large amount of value to the investment over time. Therefore, when using internal rate of return in real estate investing, it’s better to use it in evaluating investment opportunities with a similar level of risk and holding period to not make mistakes when choosing the best real estate investment.
3. Often, investors can become lazy and simply rely on the IRR percentage without taking into consideration the assumptions used in the calculation. As a result, it may end up oversimplifying what might often be a complex investment.
4. Your calculations of the internal rate of return in real estate investing 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.
Tools for Calculating Internal Rate of Return
As you can see, it is difficult to calculate the internal rate of return by hand. Solving the previous equation by hand requires trial and error until you find a value for IRR that makes the equation equal to zero.
Luckily, there are various software programs that help real estate investors and make the internal rate of return calculation a piece of cake. For instance, there is a simple Excel formula for calculating the internal rate of return. The investment property calculator is another tool which offers this option.
Mashvisor offers a selection of tools that will help you in facilitating your search for new real estate properties, including an investment property calculator, to help you with the real estate market analysis and allow you to make the best real estate investment decisions.
Advantages of Calculating Internal Rate of Return on Investment
It is helpful when comparing the worth of different investment opportunities based on their return. Assuming that all investment properties require the same amount of upfront investment, the property with the highest IRR (generates the highest cash flow) would be considered the best.
Furthermore, IRR provides you with a clearer picture of the type of returns which your investment will generate from beginning to end, which is something average return on investment (ROI) metrics don’t offer. This is very helpful if you’re planning to invest in real estate for a long period of time.
However, the internal rate of return in real estate investing requires a large number of assumptions about future events which may or may not actually be true. Basically, you’re assuming how the overall market is going to perform and the amount of cash flow that will be generated, which are things you can’t be sure of. In addition, it ignores future costs; therefore, your calculations can be useless if any unexpected costs arise.
Internal Rate of Return and Net Present Value
Unlike the average real estate return on investment metrics, the internal rate of return in real estate investing is associated with another real estate investment term – the net present value (NPV). The NPV is the sum of the present value of incoming cash flow minus the outgoing cash flow over a period of time.
You can estimate real estate IRR mathematically by setting the net present value (NPV) equation equal to zero (0) and then solving for the rate of return. Here’s the equation to calculate IRR:
NPV = ∑_(n=0)^N (Cn / (1+r)^n) = 0
Where:
 N: The total number of years.
 Cn: Cash flow in the current period at that step in the formula.
 n: The current period at that step in the formula.
 r: Internal rate of return in real estate investing.
When analyzing the internal rate of return in real estate investing, it’s important to realize that timing plays an important role. The difference between real estate IRR and other average real estate return on investment metrics is that the duration of the investment’s hold period and the timing that cash flows are paid to investors both have a big influence on this equation.
Internal Rate of Return (IRR) vs. Return on Investment (ROI)
The return on investment (ROI) and the internal rate of return (IRR) sound almost the same, right? Let’s discuss the differences between IRR vs. ROI.

Return on Investment (ROI)
The return on investment is a real estates metric that 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 investment property. It is calculated in the form of a percentage, and it expresses the total growth of the investment property, ignoring the “time value of money”.
Thus, calculating the return on investment of a real estate investment property gives you an estimated figure of what you can expect to earn for a fixed point in time. Moreover, it is only usable when comparing real estate investments over equal time frames.

Internal Rate of Return (IRR)
When calculating the internal rate of return on investment, however, we’re talking about measuring the rate earned (as a percentage) on each dollar that has been invested in the investment property. Additionally, the internal rate of return takes into consideration the “time value of money” as the rate is calculated for each period of the real estate investment.
The IRR is more precise than the ROI as it gives real estate investors the opportunity to monitor the growth of their money in the long term. Most importantly, the internal rate of return on investment is very useful when comparing real estate investments with different time frames.
Conclusion
Successful real estate investors are always thinking ahead and keeping a close eye on the numbers. The internal rate of return (IRR) in real estate investing is a widespread metric which helps real estate investors evaluate investment opportunities, measure the investment’s performance, and identify its value over time. Remember, the higher the internal rate of return on the investment property, the more desirable it is to invest in.
So, if you want to become an expert in the real estate business, understanding real estate IRR will help you in your career. Keep reading on Mashvisor for many useful tips and information on numerous real estate topics. Not only that, Mashvisor can also provide you with different real estate tools to guide you into investing in the best real estate investment properties.
Moving forward with this series of blogs concerning the rate of return, the time has come to answer the question “How do we calculate the rate of return on a rental property?”. Find the answer here!