by Contributing Author
If you’re looking to get into the real estate business, you may have heard of internal rate of return, commonly known as IRR. It’s a popular tool among investors who wish to gain a solid idea of the performance or potential performance of a real estate project. It’s not a perfect tool but it is useful. But do you know how to calculate the internal rate of return? Let’s look at that, and more.
What is IRR?
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As we say, the IRR is a way to assess the profitability, current or future, of a real estate investment. Where it particularly excels is in gauging real estate over time. In other words, it can calculate a project’s future value as if that value were in today’s dollars.
The tool’s existence is significant because, unlike stocks, real estate is a little tricky. The former’s performance can be checked with an email to your broker or by clicking on a website.
The Concepts of Profit and Time
These terms are central to how internal rate of return works because they’re meshed into one metric. “Profit” is straightforward: it’s the amount of cash an investment produces relative to the amount invested.
The “time” value of money (TVM), however, is a more dynamic concept. To wit, $500 does not carry the same value as it did 25 years ago, nor will it be worth the same 25 years from now.
So, ultimately, IRR is used by real estate investors to give them a greater feel for a property’s realized or potential profitability – as it relates to time.
The IRR Formula
Despite the tool’s widespread usage, what it excludes is as fundamental to IRR as what it encompasses. Left out are external factors such as inflation, risk-free rate, inflation, financial risk, and the cost of capital.
Having said that, the IRR formula is quite complex and involves terms such as net present value (NPV), total number of periods, non-negative integer, cash flow, and internal rate of return.
Broken down, IRR is the discount rate that renders the NPV of a property zero. Another way to put it is, IRR is the anticipated compounded annual rate of return that will be
earned on an investment. When calculating IRR, the initial cash investment will be equal to the current value of the investment’s future cash flows.
Once an IRR determination is made, it’s usually sized up against the cost of capital. It’s generally accepted that the higher the IRR, the better the investment.
Figuring IRR Quickly
As you can see from the formula above, calculating the internal rate of return manually – without an IRR calculator – can be a challenge.
However, there is a way for you to swiftly come up with an approximate IRR. Say you’re investing $100 today and in five years will get back $150. What interest rate, compounded annually, would allow you to earn $150?
To gain an approximate IRR, begin by figuring out the money-on-money multiple and the holding period. If, in a year, you double your money, that’s a 100% IRR. If it takes you two years to double your money, you must earn about 50 percent annually to hit that mark. You can apply this basic math to nearly any scenario.
If you’re a fledgling real estate investor or simply wish to learn more about how things work, we suggest that you check out the alternative platform Yieldstreet, which offers investments, including real estate, that aren’t reliant on the stock market. This is secondary income that you can generate while diversifying your investment portfolio.