When it comes to calculating the return on a real estate investment, there are a couple of different methods you could use. The two main real estate metrics you have probably heard of are the IRR (internal rate of return) and ROI (return on investment). What are these metrics exactly, and what’s the difference between the two when it comes to measuring investment performance?
Return on Investment vs Internal Rate of Return (IRR vs ROI)
Why are we even discussing IRR vs ROI? Because these two return metrics are some of the most commonly used by investors in an investment property analysis when evaluating the potential profitability of a real estate investment, or determining the performance of a completed investment. While both might seem interchangeable, each serves its own function and they have key differences. The main difference when covering IRR vs ROI is the fact that IRR takes into account the time value of money, whereas ROI does not. It’s okay if you don’t really know what that means. Let’s jump into some more details and discuss each metric separately before comparing and contrasting the two. Since IRR is usually viewed as the more complex metric, let’s get any confusion out of the way and explain it first.
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IRR: Internal Rate of Return
IRR is the rate of return (ROR) which equates the present value of an investment’s expected gains with the present value of its costs. To put it simply, it is the percentage rate earned on each dollar invested for each period of time it is invested; you can simply call this interest. The internal rate of return of an investment property is an estimate of the value it generates during the time period you own it.
You can think of IRR as the rate required to convert the sum of all future cash flow generated by this investment property to equal your initial investment. That is the key feature of IRR; its calculation accounts for the time it takes an investor to receive his or her initial investment (profit) back.
It’s the discount rate for which the net present value of an investment equates to zero. When comparing IRR vs ROI, IRR is the ROI discounted for future cash flows. This is ultimately the goal for IRR; to identify the rate of discount.
Related: Real Estate Investing Terminology: Internal Rate of Return (IRR)
IRR Pros and Cons
Because it takes into account both the amount and the actual timing of the return (time value), IRR provides a more precise evaluation and analysis when measuring potential or actual property performance. So it’s definitely a helpful tool for real estate investors. The reason some investors shy away from using this metric lies within its formula.
Although it’s expected for math to be involved in any investment, the IRR formula is a bit more complex than what you might be used to seeing in this industry. Luckily, we put together a guide to help you out: Internal Rate of Return (IRR) What Is It and How to Calculate It?
ROI: Return on Investment
When hearing IRR vs ROI, most people are only familiar with the latter. ROI is a metric which measures the amount of money or profit being made on an investment as a percentage of the property price (cost of the investment). The ROI formula can be put simply:
As you can see from the formula above, the return on investment is the percentage increase or decrease in an investment over a set period. It’s found by subtracting the original value or cost of investment from the investment’s current or expected value and then dividing it by the original cost. This number is then multiplied by 100 to get the ROI in percentage form.
ROI Pros and Cons
The ROI is a key metric used by all real estate investors because it shows how effectively and efficiently their investment dollars are being used to generate profits.
However, the problem with ROI is the precision of this return. The key part of the calculation depends on the “investment gain” or the estimation of the property’s current value. If this isn’t accurately estimated, the whole measure for the rate of return could be far from the truth.
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So what we can say about IRR vs ROI is the first can be more difficult to calculate but the second isn’t as precise. So which one do you use?
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IRR vs ROI: Is One Better Than the Other?
Not really. When it comes to measuring the performance of an investment property, it’s always best to use multiple metrics. This allows for the most accurate reflection of actual profitability and return. So it’s good to ask about IRR vs ROI to understand the differences between them, but not to use one and ignore the other. Both real estate metrics are different but they are complementary. Again, IRR differs from ROI because it accounts for cash flows being received at different times over the course of the real estate investment, whereas ROI assumes all cash flows are received at the end of the investment. ROI is great for giving you an initial estimation of investment performance, and if you like the numbers, use IRR to give you a more precise percentage of return.
Related: What Is a Good Return on Real Estate Investment?
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