It’s no secret that real estate investors need to have a good knowledge in the field in order to be successful and make money from real estate. So, in this blog, we will provide you with the knowledge you need on a concept that real estate investors should be familiar with – internal rate of return on investment.
Internal Rate of Return Definition
To become an expert in real estate investing, not only should you be aware of how much profit you would potentially gain, but you should also know when you would potentially receive it.
The internal rate of return (IRR) in real estate investing is an estimate of the value which an investment property generates during the time frame in which a real estate investor owns it. Real estate investors should think of the IRR as the rate of growth that the investment property can potentially generate.
Essentially, the internal rate of return on investment is the percentage of interest which a real estate investor receives on each dollar he/she invests in a property throughout the entire holding period.
Let’s give an example to further clarify. Suppose you’ve bought an investment property to rent out, and you plan to own this property for 10 years. You would 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 10-year period represents the internal rate of return.
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 them.
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.
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
- 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
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 up-front 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.
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.