What is IRR in Real Estate?

Checking the performance of stocks and bonds can be easily done by logging into a brokerage account for updates. However, identifying current and future real estate returns is much more difficult because the same property does not change hands every day.

Of the various financial analysis metrics available to real estate investors, IRR is one of the most often used calculations. IRR in real estate incorporates key investment criteria to help identify property that meets the specific goals of each individual investor.

What is IRR?

Internal rate of return (IRR) is a financial metric used to measure the profitability of an investment over a specific period of time and is expressed as a percentage. For example, if you have an annual IRR of 12%, that means you have 12% more of something than you did 12 months earlier.

The IRR calculation combines profit and time into one formula:

• Profit is how much cash the investment generates over the holding period compared to the amount of capital invested
• Time value of money (TVM) estimates what the current value is of money received in the future
• Opportunity cost by comparing the IRR of one investment to other alternatives

A good way to think about IRR is that it is the discount rate – or interest rate – that makes the net present value (NPV) of the cash flows you receive equal to zero.

By weighting the periodic cash flows, IRR helps you to make a fair comparison to alternative investments with cash flows that occur at different points in time. That’s because a dollar actually received today is worth more than the promise of a dollar received several years from now, due to factors such as inflation, unknown future events, and general investment risk.

As a real estate investor, you have a required rate of return on the capital being deployed in order for the investment to make sense. Everything else being equal, the investment that generates an IRR greater than or equal to your required rate of return will be worthwhile taking a closer look at.

How to Calculate IRR

The formula for calculating IRR looks like this:

Source: Corporate Finance Institute

Although it may look complicated at first, the IRR formula is easier to understand when you isolate the different parts. Now let’s look at some examples of how IRR is used in real estate investing.

Examples of calculating IRR

Let’s assume you invest $100,000 in a property with a holding period of five years. If you choose the wrong investment and have no cash flows and no profit or loss at the time of sale, your IRR is 0%.

However, the three more likely potential outcomes are:

#1: Annual cash flow and no profit from sale

• Initial investment $100,000
• Annual cash flow $12,000
• Initial investment of $100,000 recovered at the end of the five-year holding period
• IRR is 12%, which is another way of saying that the investment generated an annualized profit of 12%

#2: No annual cash flows but a profit from sale

• Initial investment $100,000
• No cash flows over the holding period
• Initial investment of $100,000 recovered plus a $25,000 profit from sale for a total of $125,000
• IRR is 4.56% because a profit was generated when the property was sold at the end of five years – note that the IRR is lower than Outcomes #1 and #3, due to the NPV and TVM concepts

#3: Annual cash flow and profit from sale

• Initial investment $100,000
• Annual cash flow $12,000
• Initial investment of $100,000 recovered plus a $25,000 profit from sale for a total of $125,000
• IRR is 15.66% because cash flows were received and a profit was made when the property was sold at the end of five years

Assuming your required rate of return is 6%, the only outcome that is worth considering is the last one with an IRR of 15.66%.

Calculate IRR using Excel

In real life, investment real estate works quite a bit differently, with cash flows varying from month to month and year over year. To easily explore different IRR scenarios, you can create a simple Excel spreadsheet with three columns:

• Column #1 for the initial investment and periodic cash flows
• Column #2 for the dates cash flows in or out
• Column #3 for the net cash flow amount

You may also want to create one field for your financing rate and another field for your reinvestment rate. Then, you can use three different Excel functions to calculate IRR:

• IRR calculates the internal rate of return without taking into account that some months have 30 days while others have 31 days
• XIRR calculates the IRR by considering the difference in time periods
• MIRR (modified internal rate of return) calculates IRR by taking into account the cost of borrowing money and the compound interest earned by reinvesting each periodic cash flow

Microsoft has an easy-to-understand guide of how to calculate NPV and IRR in Excel: Go with the cash flow

Key assumptions that affect IRR

Note that in order to calculate the potential IRR of a real estate investment you’ll need to make four assumptions:

1. Amount of periodic cash flows
2. Timing of periodic cash flows
3. Date property will be sold
4. Sales price of property

Minor changes in these four assumptions can have a significant impact on your IRR, such as receiving cash flows monthly or annually.

For example, if you invest $100,000 and receive $1,000 the first month, you now have $101,000. That’s 1% more than your original investment, and a monthly IRR of 1%.

Assuming your investment grows by 1% each month, in the second month you would have made $102,010 ($101,000 x 1.01), and by the end of 12 months you would have made a total of $12,682.50 from your original investment.

The annual IRR of 12.68% ($112,682.50 / $100,000) – 1 = 0.1268 or 12.68%. On the other hand, if you received a single annual distribution of $12,000 from your $100,000 investment, your annual IRR would be just 12%.

What is a Good IRR?

IRR is a comprehensive way of thinking about the potential profitability of a real estate investment.

When you think about what a good IRR is, it’s important to take a detailed look at the prospective investment and understand that an IRR isn’t always what it appears to be.

For example, a project may boast a big top-level IRR, but the net IRR to you as an investor is lower because of asset management fees taken by the developer or sponsor before distributions are made. On the other hand, an IRR may be understated due to the industry standard of calculating investment returns on an annual basis, when distributions are actually made monthly or quarterly.

Core Plus, Core, and Value Add investments will also yield different IRRs due to the anticipated income stability and the level of risk:

• Core Plus investments will generate a lower but very predictable IRR similar to the regular payment schedule of a bond or stock dividend, with little upside or downside
• Core properties will return slightly higher IRRs due to gradually increasing cash flows and an upside gain when the property is sold
• Value Add projects may provide higher IRRs, although the periodic cash flows may be uneven, and the gain on sale greater than a Core Plus investment

How Does IRR Compare with Other Real Estate Formulas and Calculations?

IRR is a good way to calculate the potential returns of a specific property. However, the IRR calculation is just one of the many formulas you can use to calculate investment returns:

Levered vs Unlevered IRR

Levered or leveraged IRR uses the cash flows when a property is financed, while unlevered or unleveraged IRR is based on an all cash purchase.

Unlevered IRR is often used for calculating the IRR of a project, because an IRR that is unlevered is only affected by the operating risks of the investment. On the other hand, levered IRR is influenced by both the operating risks and potential financing risks such as interest rate changes or the lender requirement for an additional down payment if the property is underperforming.

The IRR and MIRR functions in Excel can be used to calculate potential IRRs for investments that are unleveraged and leveraged.

IRR vs NPV

Both IRR and NPV have several things in common such as using periodic cash flows, taking into account the time value of money, assumed rental rates, and exit selling price. But there are some significant differences between IRR and NPV as well.

NPV indicates the potential return on a project in terms of dollars, while IRR represents a percentage return. When investing in a value add property, NPV may provide a better idea of a project’s value. NPV does not change if cash flows fluctuate between positive and negative over the holding period while IRR results may be ambiguous.

IRR vs ROI

ROI provides a quick measurement of return by dividing the gain from an investment by the cost of the investment. While calculating ROI is easy to do and understand, it is best used for investments held for a short period of time. That’s because ROI does not take into account the length of time needed to generate the return, so an investment held for one year or 50 years could have the same ROI.

ROI focuses on profits rather than distributions. As with NPV, the ROI calculation is not affected by cash flows that change from positive to negative and back again, while calculating the IRR of an investment with varying cash flows can lead to inconclusive results.

IRR vs Equity Multiple

Equity multiple is calculated by dividing the total cash distributions from an investment to the amount of equity invested. If you invest $100,000 and get back $300,000, your equity multiple is 3.0. On the other hand, IRR measures the compounded annual percentage rate earned on each dollar invested over the holding period, and also takes into account the time value of money.

Because of the way IRR is calculated, a property may offer a high IRR and return your capital faster but may not create more profit. Both IRR and equity multiple are important calculations to understand, but by putting too much emphasis on IRR an investor may overlook a property that generates greater returns on equity.

Cash on Cash Return vs IRR

IRR measures your total return of the entire holding period of an investment, while cash on cash return gives you the current return on your investment. Cash on cash is calculated by dividing the cash received over a certain period of time – usually a given year – by the cash invested to realize that return.

For example, a property that returns $10,000 in profits from a $100,000 investment would have a cash on cash return of 10%. If the profits next year are $5,000, the cash on cash return would be 5%, followed by 15% in year three if the property generates profits of $15,000. Using this same scenario, the IRR would be 9.85% over the holding period, including return of the original investment.

IRR vs XIRR

XIRR is an Excel function that allows you to assign specific dates in each periodic cash flow, which in turn makes the internal rate of return calculation more accurate. That’s because the IRR function in Excel calculates the internal rate of return over annual periods at the end of the year.

Because IRR calculations are time sensitive and give more weight to cash flows that are received earlier in the investment, using XIRR to tell Excel that cash flows begin in Q1 or Q2 rather in one lump sum on December 31^st can have a significant positive impact on the calculated rate of return.

IRR vs WACC

WACC (weighted average cost of capital) represents the combined average cost of equity and debt used to acquire an investment. Investors use WACC to set the minimum base rate of return before deciding whether or not to invest.

The formula for WACC weights the cost of equity and debt used to finance a property using the following formula:

• WACC = (LTV) * C_D + (1-LTV) * C_E
• WACC = 0.65 * 0.05 + 0.35 * 0.12 = 0.0325 + 0.042 = 3.25% + 4.20% = 7.45%

With LTV being the loan-to-value ratio, C_D the interest rate of the loan, and C_E the required rate of return or IRR by investors. In the above example, the required rate of return is 0.12 or 12%, which must be greater than the WACC in order to cover the cost of financing.

IRR vs TWR

TWR (time weighted return) is normally used in open-end investment funds to capture the true performance of a property by eliminating the effects of capital contributions, withdrawals, management, and advisory fees. The calculation allows an investor to analyze the true performance of an asset and the investment manager, versus just the return on capital invested.

TWR is calculated by dividing performance periods into monthly or quarterly intervals, calculating the IRR for each interval, then linking the periodic IRRs together to determine the overall TWR of an investment.

In essence, TWR calculates the return if the property were purchased at the beginning of each period and sold at the end of each period. By contrast, the traditional IRR calculation is based on the initial acquisition price, periodic cash flows, and sale price at the end of the holding period.

Practicing Sound Real Estate Risk Management

It’s important not to rely on any single metric when you analyze potential real estate investments, and IRR is no exception.

To be fair, IRR does provide several advantages, such as the timing and present value of future cash flows, ability to compare the potential returns of a project to your unique investment criteria, and relative ease of calculation when using an Excel spreadsheet or financial calculator.

However, the IRR of an investment does not take into account important factors such as the viability and risk of a project, unanticipated capital expenses, or the actual profit in terms of dollars. Future rental rates and vacancy levels can also be difficult to predict, with erroneous assumptions making an IRR calculation widely overstated.

Lastly, as we’ve seen in this article, IRR calculations can easily be manipulated to make returns greater than what they actually are to an investor.

That’s why it’s important for investors to develop their own set of metrics and calculations to use when evaluating a potential real estate investment. At the end of the day, IRR is just one of many ways to help decide whether or not a property makes good investment sense for you.