Have you heard of internal rate of return in real estate investing before? To turn a profit on investments, real estate investors need to know how to balance risks against potential rewards. Calculating the return on investment (ROI) of a real estate investment property can give you an estimated figure of what you can expect to earn for a fixed point in time. However, the internal rate of return in real estate investing (IRR) is an investment metrics more precise than the rental property ROI, used to measure investment properties’ long-term yield, and is a concept that real estate investors should be familiar with.
Defining Internal Rate of Return (IRR)
To become an expert real estate investor, not only should you be aware of how much money you would potentially obtain, but you should also know when you would potentially receive it. The internal rate of return in real estate investing is an estimate of the value that an investment property generates during the time frame in which you own it. Investors should think of the internal rate of return in real estate investing as the rate of growth a real estate investment can potentially generate. Essentially, the IRR is the percentage of interest you earn on each dollar you invest in a property over the entire holding period.
For example, suppose you purchased an investment property to rent out, and you plan to own the property for 10 years. You’d 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 IRR.
Internal Rate of Return and Net Present Value
Unlike the average real estate return on investment metrics, the internal rate of return in real estate investing is associated with another real estate investment term – the net present value (NPV). The NPV is the sum of the present value of incoming cash flow minus the outgoing cash flow over a period of time.
You can estimate real estate IRR mathematically by setting the net present value (NPV) equation equal to zero (0) and then solving for the rate of return. Here’s the equation to calculate IRR:
NPV = ∑_(n=0)^N (Cn / (1+r)^n) = 0
Where:
- N: The total number of years.
- Cn: Cash flow in the current period at that step in the formula.
- n: The current period at that step in the formula.
- r: Internal rate of return in real estate investing.
When analyzing the internal rate of return in real estate investing, it’s important to realize that timing plays an important role. The difference between real estate IRR and other average real estate return on investment metrics is that the duration of the investment’s hold period and the timing that cash flows are paid to investors both have a big influence on this equation.
An Example of Internal Rate of Return
When you buy a rental property, the investment is made up of one outgoing cash flow (suppose you purchased the property with $123,400) followed by multiple incoming cash flows (regular rent payments). Suppose 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+r)1 + 54800/(1+r)2 + 48100/(1+r)3 = 0
Solving the equation by hand requires trial and error until you find a value for r that makes the equation equal to zero. Fortunately, software programs like Excel provide a simple function for solving the equation which makes IRR calculations a piece of cake. Notice that when using a rental property ROI calculator, you’ll get different results.
Related: Using an Investment Property Calculator: The Pros and Cons
You now may be asking “What is good IRR?”. In general, if the internal rate of return is greater than the initial investment, then it is considered a good IRR and it is a good idea to pursue the investment. Similarly, if the IRR is lower than the initial investment, then it may be best to reject it. Moreover, if you want to know what is good IRR, factors such as investment size, the holding period, and the incoming and outgoing cash flow need to be taken into consideration.
Why Calculating Internal Rate of Return in Real Estate Investing Is Useful
1. Real estate IRR is a comprehensive way to estimate a real estate investment’s profitability. Since the IRR looks beyond the property’s net operating income (NOI) and its purchase price (used in calculating the cap rate), you will get a clearer picture of the type of returns which the investment will generate from beginning to end, which is something average real estate return on investment metrics don’t offer. This is extremely helpful for you if you want to become an expert real estate investor and are planning to invest in real estate for a long period of time.
2. Simplicity: IRR is an easy metric to calculate; it is a single percent figure that takes into account multiple factors such as incoming cash flows and outgoing cash flows, as well as financing costs and appreciation.
3. The internal rate of return in real estate investing gives real estate investors the means to compare alternative investments based on their return.
Limitations of Internal Rate of Return in Real Estate Investing
While the internal rate of return can tell you a lot about investment properties, there are disadvantages to relying on it to compare real estate investments.
1. The internal rate of return in real estate investing requires a large number of assumptions about future events which may or may not end up being true. You’re basically making assumptions about how the overall market is going to perform and the amount of cash flow that investment properties will generate, which are things you can’t be sure of.
2. Real estate IRR fails to compare investments of different lengths. For example, an investment of a short duration may have a high IRR, making it appear to be the best real estate investment, but it may also have a low NPV. On the other hand, an investment with a longer time frame may have a low IRR – earning returns slowly and steadily – but may add a large amount of value to the investment over time. Therefore, when using internal rate of return in real estate investing, it’s better to use it in evaluating investment opportunities with a similar level of risk and holding period to not make mistakes when choosing the best real estate investment.
Related: How Can You Choose the Best Real Estate Investment Types for You?
3. Often, investors can become lazy and simply rely on the IRR percentage without taking into consideration the assumptions used in the calculation. As a result, it may end up oversimplifying what might often be a complex investment.
4. Your calculations of the internal rate of return in real estate investing can become useless if any unexpected costs arise or if you can’t sustain the type of rental income you had in mind at the start of the investment.
Conclusion
In real estate, thinking ahead and keeping a close eye on the numbers is always smart. The internal rate of return in real estate investing is a popular metric which helps investors evaluate real estate opportunities, measure investment performance, and identify its value over time. To calculate the IRR, you’ll need to identify expected cash flows for each year, accounting for outflows in the first year. These factors also need to be considered when estimating what is good IRR. So, if you want to become an expert real estate investor, understanding real estate IRR will help you in your career. If you have more question on real estate investing and want to improve your ability to find the best real estate investment, visit Mashvisor.
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