IRR (Internal Rate of Return)

 

 

The internal rate of return (IRR) is a sophisticated financial metric used by investors to evaluate the overall profitability of an investment over its entire holding period. IRR takes into account the time value of money, recognizing that a dollar received today is worth more than a dollar received in the future. 

 

IRR is both difficult to manually calculate and define in an easy to understand manner.  A verbose description/definition of IRR is as follows: "IRR represents the annualized rate of return at which the net present value (NPV) of an investment's cash inflows and outflows becomes zero. In other words, it is the rate at which an investment breaks even in terms of its NPV."

 

A simpler definition of IRR is:  "IRR is the rate of return each dollar in an investment earns while it is in the investment."

 

Different than cap rate or cash on cash, IRR is a multi-year metric with the ability to incorporate the entire life cycle of an investment, from the initial acquisition and financing costs to ongoing operating expenses, rental income, and eventual sale proceeds. This holistic approach enables investors to capture the full range of financial benefits and risks associated with a particular property and make more informed investment decisions.

 

Calculating the IRR can be complex, as it often requires iterative calculations or the use of financial calculators or specialized financial software. However, the IRR offers a comprehensive measure of an investment's performance, allowing investors to compare different investment opportunities and determine the most attractive option based on their expected returns.  Manually calculating IRR is beyond the scope of this course, and we will instead rely on software to calculate it for us.

 

In conclusion, the internal rate of return is a powerful tool for evaluating the overall profitability of real estate investments, taking into account the time value of money and providing a comprehensive measure of an investment's performance over its entire holding period. By understanding how to calculate the IRR and using it in conjunction with other financial metrics, investors can better navigate the complex world of real estate investing and maximize their returns.