What does IRR Mean in Real Estate and How to Use it?

What does IRR Mean in Real Estate and How to Use it?

When evaluating financial investments on past performance or future potential, an investor wants a definite measure to gauge return. Unlike securities such as stocks, determining the return of real estate properties is not as simple as checking a stock exchange. There are many layers to investing in commercial and non-commercial real estate, which can complicate a clean metric for an investor's return.

Therefore, this article defines and explains an all-encompassing measure in real estate for profitability: internal rate of return (IRR).

Key Takeaways

  1. IRR reflects the yearly growth rate of an investment
  2. IRR is useful in an apples-to-apples comparison of investment opportunities with equivalent risk and life span
  3. IRR is a projection tool to determine the profitability of a property

What is IRR in Real Estate?

IRR in real estate is simply the annualized rate of return during the lifetime of an investment. In other words, if an investor owned an asset that distributes the same amount of capital and held it for the same time period, the yearly percent change would be the IRR.

IRR proves useful because it encompasses the time value of money for the cash flows of a project. The time value of money is the idea that money currently is more valuable than money in the future. The cash flows represent the income and expenses from holding the property.

Usually, the IRR is expressed in a percentage and an annual measure. Therefore, the cash flows must be calculated on a yearly basis.

How to Calculate IRR in Real Estate?

In mathematical terms, IRR is the discount rate for which the net present value is 0. Net present value (NPV) is the total value for all the cash flows expressed in the current time period's value of money. Discount rate is another way of saying interest rate, but it is used to describe the decay of money's value over time.

IRR formula looks like:

NPV=n=0NCFn(1+IRR)nNPV = \displaystyle\sum_{n=0}^N \frac{CF_n}{(1+IRR)^n}
NPV=Net Present ValueNPV = Net \space Present \space Value
N=Year Property SoldN = Year \space Property \space Sold
CFn=Cash Flow for Year nCF_n = Cash \space Flow \space for \space Year \space n

The formula above broken down is the net present value equivalent to the sum of cash flows as discount rate IRR starting from year 0 to year N.

The cash flows of the property come from income such as rent and amenities minus the expenses such as management fees and operation costs. The calculation of IRR takes the investor's perspective, so the inflows are represented as positive numbers and the outflows as negative numbers.

Since the calculation of IRR requires upper-level math skills, there are online calculators and software applications such as excel to alleviate the process.

Important Fact: If investing in a real estate project, the initial cost and final sale of the property should be included in the cash flows.

What is an Example of IRR in Real Estate?

Assume a real estate investor is interested in buying an apartment building and plans to hold the property for five years.

The investor anticipates purchasing the property for $100k, receiving $10k cash flows per year, and selling the property for $120k in the fourth year.

The calculation for IRR looks like:

NPV=CF0 + CF1(1+IRR) + CF2(1+IRR)2 + CF3(1+IRR)3 + CF4(1+IRR)4NPV = CF_0 \space + \space \frac{CF_1}{(1+IRR)} \space + \space \frac{CF_2}{(1+IRR)^2} \space + \space \frac{CF_3}{(1+IRR)^3} \space + \space \frac{CF_4}{(1+IRR)^4}
0=$100k + $10k(1+IRR) + $10k(1+IRR)2 + $10k(1+IRR)3 + $120k+$10k(1+IRR)40 = -\$100k \space+\space\frac{\$10k}{(1+IRR)}\space+\space\frac{\$10k}{(1+IRR)^2}\space+\space\frac{\$10k}{(1+IRR)^3}\space+\space\frac{\$120k + \$10k}{(1+IRR)^4}

Based on the formula, the investor finds the IRR to be 14.061% . Now, the investor has to decide if the risk profile and IRR provide enough justification to pursue this project.

In another example, assume the real estate investor finds two real estate projects to invest in for five years.

Project A has an initial and final cost of $200k with cash flows of $5k and one $25k cash flow in year 2. Project B has the same initial and final cash flows but in year 4 has the $25k cash flow.

NPV=CF0 + CF1(1+IRR) + CF2(1+IRR)2 + CF3(1+IRR)3 + CF4(1+IRR)4 + CF5(1+IRR)5NPV = CF_0 \space + \space \frac{CF_1}{(1+IRR)} \space + \space \frac{CF_2}{(1+IRR)^2} \space + \space \frac{CF_3}{(1+IRR)^3} \space + \space \frac{CF_4}{(1+IRR)^4} \space + \space \frac{CF_5}{(1+IRR)^5}
0=$200k + $25k(1+IRRA) + $5k(1+IRRA)2 + $5k(1+IRRA)3 + $5k(1+IRRA)4 + ($5k +$200k)(1+IRRA)50 = -\$200k \space+\space\frac{\$25k}{(1+IRR_A)}\space+\space\frac{\$5k}{(1+IRR_A)^2}\space+\space\frac{\$5k}{(1+IRR_A)^3}\space+\space\frac{\$5k}{(1+IRR_A)^4} \space+\space\frac{(\$5k \space + \$200k)}{(1+IRR_A)^5}
0=$200k + $5k(1+IRRB) + $5k(1+IRRB)2 + $5k(1+IRRB)3 + $25k(1+IRRB)4 + ($5k +$200k)(1+IRRB)50 = -\$200k \space+\space\frac{\$5k}{(1+IRR_B)}\space+\space\frac{\$5k}{(1+ IRR_B)^2}\space+\space\frac{\$5k}{(1+ IRR_B)^3}\space+\space\frac{\$25k}{(1+ IRR_B)^4}\space+\space\frac{(\$5k \space + \$200k)}{(1+ IRR_B)^5}

Therefore, Project A and Project B have an IRR of 4.687% and 4.412%, respectively. The difference in the IRRs highlights the influence of time on the distributions of cash flows. The more profitable project depends on the investor's desire for cash in the beginning of the period or later.

What is the Use of IRR?

IRR determines the growth of a project over time whether short-term or long-term investing.

By accounting for the time value of money, IRR provides a metric to compare properties with similar risk profiles. IRR also has utility in assessing across different asset classes as long as the holding period of the assets and risk are relatively equivalent.

In comparison to another financial performance metric, return on investment (ROI), IRR includes the future procurement of cash flows whereas ROI reflects on the past performance of cash flows. Both ROI and IRR express the growth of an investment from start to finish, but ROI neglects to include the time value of money.

Investors can see the effect of leverage on returns by calculating levered IRR. If an investor wants to produce a levered IRR, the cash flows include the debt payments. As a result, levered IRR will usually be lower than unlevered IRR as debt payments lower cash flows.

What is a Good IRR in Real Estate?

The concept of one "good" IRR fails to occur due to the variation in property types, geographic location, market conditions, and investor. If those factors are accounted for, the investor can estimate a reasonable IRR.

The vision for the property by the investor heavily influences the outlook of IRR. For short-term investing, a higher IRR may be advantageous as higher cash flows at the beginning of a time period lead to higher IRRs. This phenomenon occurs due to the time value of money as capital today is more valuable.

In contrast, a long-term investor that holds a property for more than ten years may expect a lower IRR compared to an investor that only keeps the property for five years.

An investor can utilize comparison analysis to find if an IRR is good for a property by determining the IRRs of similar property types within the geographic location. When macroeconomic conditions are considered, an investor has a realistic indication of IRR.

In general, an IRR that is higher indicates more return. At times, a higher IRR may not be persuasive enough due to the risk of the investment.

What are the Limitations of IRR?

While IRR can be useful to a real estate investor, it falls under limitations to the extent of its use.

IRR utilizes projections and forecasted values for cash flows. These assumptions can be used to mislead investors as they are not guaranteed and are subject to change over time.

The cash flows of a property can vary drastically year by year as capital expenditures, large upgrades and repairs, can occur. Also, the value of the property at the time of sale can be difficult to predict as market conditions change over time due to interest rates and supply/demand oscillating.

In comparison analysis, IRR has to be used for assets with equivalent holding periods. Otherwise, IRR could be an inaccurate measurement due to incorporating the time value of money.

Risk varies drastically on market conditions, geographic location, and property type. Unfortunately, IRR does not incorporate risk into the calculation. Therefore, investors have to evaluate properties with additional financial metrics to provide a holistic view.

What is MOIC vs IRR?

Multiple on invested capital (MOIC) measures the total value generated by a project. MOIC takes into account realized value, unrealized value, and total cash invested. The realized value is past expenses or revenues whereas unrealized value is parts of the project that have not been generated.

MOIC has the formula of unrealized value summed with realized value over total cash invested, which looks like:

MOIC=Realized Value + Unrealized ValueTotal Cash InvestedMOIC = \frac{Realized \space Value \space + \space Unrealized \space Value}{Total \space Cash \space Invested}

Similar to IRR, MOIC determines the profitability of a project. On the same lines, in general a higher MOIC correlates to more value for the investor.

MOIC differs in IRR in that MOIC does not account for the time value of money and fluctuates depending on quantity instead of when.

Since MOIC takes into account total cash invested, MOIC is an unlevered metric.

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