Internal Rate of Return (IRR) is one of the most widely cited metrics of performance in real estate and probably the least understood. What is IRR and why does it matter?
The simple answer is that many people view IRR as the most accurate return metric because it takes into account the widest array of variables that could affect the investment.
How is IRR Calculated?
IRR is the average annual return a project is expected to generate over the lifetime of the investment.
Another way to think about IRR is the interest rate that would the net present value of an asset equal to zero. Meaning the cost to purchase the asset today is equal to the projected value of that asset in the future.
Here’s what these terms actually mean:
- Exit Value: Calculated by dividing the next 12 months of net operating income from an asset by the cap rate. Exit Value has the greatest effect on an IRR and is also the most difficult to calculate accurately because of assumptions that need to be made about future cash flows.
- Present Value: What the asset is worth today, taking into consideration the duration of the investment (i.e. time). Present Value is based on the assumption that money today is more valuable than potential money in the future because of the uncertainty of the future.
- Net Present Value: The Present Value of an asset less the initial investment required to obtain the asset.
Once the IRR has been calculated, a decision can be made about the investment’s profitability. If the calculated IRR is greater than zero, the investment is expected to result in a profit. If the IRR is less than zero, then the investment will not likely yield a return.
What Are the Limitations of IRR?
Calculating IRR requires you to make assumptions about future events, cap rates, cash-flows, and general market conditions. Because of these limitations, any IRR should be taken with a grain of salt and is best used to compare investments that are similar in risk and duration — think of it as a way to compare two pairs of socks, rather than a way to compare socks to shoes.
As always, a smart real estate investor should think critically before making any investment and IRR should be viewed as one of many predictive tools to help analyze an opportunity. It is important to remember to understand the underlying assumptions being made when using IRR as a predictor, just the number alone doesn’t mean much on its own.