What is internal rate of return? What does it tell you about the viability of an investment? When is it particularly useful? How do you calculate it? Here’s everything you need to know about IRR or internal rate of return.
Understanding internal rate of return
Among commonly-used metrics for commercial real estate investors, the internal rate of return (IRR) is distinct in several ways.
- IRR factors in the time value of money. Unlike most metrics used by real estate investors, the internal rate of return recognizes that money earned now is more valuable than the same amount earned in 1 year, and that money earned in 1 year is worth more than the same amount earned in 5 years.
- IRR is complicated to calculate without using an internal rate of return calculator or functions in microsoft excel. Because it factors in the time value of money, the internal rate of return is based on the Net Present Value formula you may recall from any finance course you took. The formula looks intimidating.
- IRR is defined as the interest rate that makes the Net Present Value (NPV) of all future cash flows from the investment equal to zero. If that definition confuses you, think of it this way. The internal rate of return compares your initial cash investment in the beginning period with the present value of all the cash flows you expect from that investment in the future. IRR sets the amount you invest equal to the present value of future cash flows you expect from the investment; therefore, the net present value = 0.
- An IRR greater than 0 means your investment is earning money, even after the future cash inflows are discounted to reflect the fact that $1 earned today is worth more than $1 earned in the future.
Calculating internal rate of return
The formula for IRR is:
Where:
CFₙ = cash flows from your investment
n = each period
N = holding period of the property
IRR = internal rate of return
The 0 that is the “answer” to formula is the NPV. To solve for IRR requires manipulating a complex formula, and is tricky. Using a spreadsheet software like Excel simplifies the calculation. Using an online internal rate of return calculator is even easier.
Here’s an example computed using an online calculator.
You purchase a small commercial rental unit in your hometown of Jackson, MS because you understand the market dynamics, and have a working relationship with a trusted lender. You pay $150,000 for the property which you expect to hold for 4 years. You anticipate cash inflows of
$37,000, $45,000, $50,000 and $55,000.
When you enter those data into the IRR calculator, you get an IRR of 8.83% Whether or not that is a “good” return on investment depends on several factors including the cost of capital if you leverage the purchase, your market, the type of commercial property you’re purchasing, and your investment goals.
You can also incorporate your exit (disposition) to realize your total return of the life of the deal. To further clarify, let’s assume you sold the property referenced in the example above at the end of the 4th year for $155,000. With the cash inflows increasing to $210,000 ($55,000 + $155,000), your IRR equates to 30.40%.
Strengths and limitations of the IRR metric
No single metric considers every aspect of a possible investment. Here are the inherent strengths and limitations of IRR.
Strengths:
Long-term Perspective: IRR captures the long-term profitability of properties. Unlike ROI, cash on cash return, or other popular metrics, IRR calculates the benefit of a property held for the long haul.
Optimal holding time: Since IRR requires estimates of yearly cash flows, it may signal the best time to sell a property. A property with slightly increasing cash flows may yield a lower IRR since the income will not be received for several years into the future.
Limitations:
Does not account for external factors: IRR is in “internal” metric because it does not factor in externals like inflation or the cost of capital.
Works poorly when comparing investments of different lengths. If you’re considering 2 commercial properties you intend to hold for 5 years, IRR provides an excellent means to do so. However, IRR analysis of long-term investments with a slightly lower internal rate of return may be overlooked even though they would provide steady income and allow you to avoid pitfalls encountered if economic conditions change and make lower internal rates of return the norm.
Summary
Because the internal rate of return considers the time value of money, it provides commercial real estate investors with information that other metrics can’t. It allows investors to weigh the comparative strengths of alternative properties not just on the amount of overall income, but also on the timing of that income.
IRR shouldn’t be used alone; it looks only at internal factors. However, when used in combination with other metrics such as equity multiple and cap rate, is a valuable tool in any commercial real estate investor’s toolbox.