Internal rate of return (IRR) is one of the most commonly utilized metrics in real estate investing. But what exactly is IRR, and why is it so important for real estate investors to understand?
Learn about the importance of IRR in real estate investments
As with any kind of investment, real estate investors need reliable methods for calculating the profitability of their ventures. Unfortunately, the real estate market isn’t as straightforward as the stock market, and there are various factors, both within and outside the control of a real estate investor, that can affect the value of a property and ultimately the performance of an investment over time.
One of the most popular methods used by real estate investors to calculate the profitability of both existing and potential investments is to determine its Internal Rate of Return (IRR). Through the increasingly common practice of calculating IRR, real estate investors can more easily navigate the inherent complexity of the real estate market and make more informed decisions about when and where to invest their money.
Let’s take a closer look at exactly what IRR is, how it’s used in real estate investing, and why it’s so important to a real estate investor’s ability to calculate and anticipate the performance of their investments.
Internal rate of return, or IRR, is a metric often used by investors to calculate the expected average rate of return on an investment. An IRR can relate to both the performance of an existing investment as well as what can be expected from a potential investment. IRR is expressed as a percentage, and importantly its overall function is not much different than that of other metrics in the finance world: letting investors know what they can expect to earn from an investment, on average, over an extended period of time, or calculating what is most commonly referred to as an annualized rate of return.
Just as there are various considerations that need to be taken into account when investing in real estate, IRR calculations are made based on multiple factors and data points. Although the totality of factors is almost always relatively varied and dynamic, IRR is primarily concerned with the reconciliation of two main factors: profit and time.
In real estate, profit can be realized as anything from scheduled rent or mortgage payments to the cash sale of a property. The profit metrics that real estate investors take into account when calculating IRR will depend on their overall business model or investment strategy. In general, any earnings that bring an investor’s balance sheet above the amount of their initial investment can be considered profit. However, and particularly in the case of real estate investing, investors will also need to deduct the costs associated with each investment, such as property taxes or those related to the ongoing maintenance, in order to accurately calculate their profits.
Time, on the other hand, is significantly more complex when considered in the context of determining an IRR. We have all undoubtedly heard the phrase “time is money” throughout the course of our lives, but when we’re talking about real estate investing, this is quite literally the case, and it turns out to be true on more than one level. For example, current and predicted trends in the housing market will have a direct impact on the value of a property at any given point in time. Similarly, inflation and the broader implications of the economy at large directly impact the value of currency itself; i.e., $1 today doesn’t have the same value as it did ten years ago, nor will it have the same value ten years from now. As time goes by, the value of money, and therefore profit, inevitably changes.
So, in a nutshell, we can ultimately say that IRR is a tool used by real estate investors to better understand an investment’s realized or potential profitability as it relates to time in a variety of ways.
IRR is particularly important for real estate investors for a number of reasons, many of which stem from the fact that there are a limited number of alternative methods for calculating the profitability of a real estate investment. As mentioned earlier, the activity of real estate investments isn’t tracked publicly like stocks and bonds, so it isn’t as simple as checking a brokerage account in the morning, or even turning on the television to check the status of a particular asset. On the contrary, real estate is a private asset, which means its value tends to be influenced by more specific, individualized variables than publicly traded assets or corporations.
Critically, however, that does not mean that real estate investments can’t also be affected by the same variables that influence public assets. At the end of the day, the economy is the economy, and its daily, monthly, and yearly fluctuations inevitably have a significant impact on everything from the actual value of currency, the principle of supply and demand, and the spending behavior of entire populations. Therefore, real estate investors often need to take much more into account than those who are primarily concerned with the performance of publicly traded stocks and bonds.
Additionally, while IRR is a great tool for calculating actual profits derived from existing investments, it is especially important for real estate investors looking to predict the rates of return on potential investments. This is because, in almost any case, estimating the profitability of a real estate investment will involve a lot of guesswork. There are simply too many independent or unknown variables at play, meaning an investor’s projections will almost always need to made based on a set of assumptions. By using a metric such as IRR as the supporting foundation for the unavoidable guesswork involved in estimating future profits, real estate investors end up with much more educated assumptions about how their investments will perform. In the absence of a trusted measurement tool like IRR, real estate investors are much more likely to make unsupported assumptions that turn out to be misguided or entirely false.
Finally, IRR is important for investors to measure the potential profitability of a particular real estate investment as compared to others, or to an alternative use of their capital, such as a more traditional investment in the stock market. For example, if a real estate investor has the option to invest in multiple different properties, it will be crucial to evaluate the potential returns of each investment as accurately as possible in order to make the smartest choice. By applying the same IRR formula across a variety of opportunities, real estate investors can see the possible benefits and pitfalls of each and then analyze these projections side-by-side. And because the IRR formula can also be applied to investments based in other markets, the same tactic can be used to determine whether a particular real estate investment would be favorable to an alternative opportunity.
By appearances, the IRR formula is not what many would consider simple arithmetic. The good news, however, is that you don’t necessarily need to be a math whiz to be a successful investor, and in most cases the real math will be calculated through the use of intuitive tools like Excel spreadsheets.
The key to understanding and calculating IRR in practice is first establishing what each variable within the formula is meant to represent. Here’s a brief explanation of those variables:
NPV – Net Present Value (to be discussed in a later section)
IRR – Internal Rate of Return
CFn – Current cashflow derived from the investment
N – Number of years the investment has been held (when calculating annually)n – The current year to which the formula is being applied (when calculating annually)
It’s important to note here that, regardless of the apparent complexity portrayed by the formula, IRR can and should be understood as a relatively straightforward method for determining the potential favorability of an investment. In the context of real estate, IRR is essentially asking basic questions related to the performance of a property investment, or more specifically, related to cashflow: What cashflow has gone into the property, both initially and throughout the current lifecycle of the investment; what cashflow has come out of the investment, both in the form of the property’s current valuation and associated streams of revenue; when is all this happening; and does the property constitute a favorable investment based on all of the above?
For a more in-depth look at how IRR is calculated from a mathematical perspective, and how the formula can be distinguished from another popular metric, Return on Investment (ROI), check out our previous article on the topic here.
Real estate investors can use IRR to evaluate the overall favorability of any property investment based on the investment’s expected returns, but it is primarily applied in two distinct scenarios: either they are considering investing in a property or they already have a property investment and are trying to decide what to do with it.
Before looking at some specific examples, it’s important to first understand what is meant by returns, and to distinguish between two critical variations: notional returns, and realized returns.
A notional return is the amount that a property would earn an investor if they took a certain action, such as executing the sale of the property. For example, if a real estate investor has invested $250K into a property over a two year period, and the property is now valued at $500K, the investor has earned a notional return of $250K. In other words, the investor is only in possession of an asset that holds a certain value at a specific point in time, they are not in possession of an actual cash return. But if the same investor were to execute the sale of the property at the time of the valuation, the $250K would become their actual, or realized return. The difference here is critical for understanding the various reasons a real estate investor might calculate the IRR of a property investment.
Now let’s take a look at a couple of examples.
Let’s say an investor has owned a house for one year and invested a total of $2M into the property (this includes the initial purchase, current maintenance costs, and property taxes). Today, the investor sees that the house is now valued at $2.1M, representing a notional return of $100K. So what is our investor going to do with this information? Sell the property for a realized return of $100K, or wait to sell in anticipation that the return will increase significantly over time?
It’s at this point in our first example when an investor might consult the IRR formula to determine a course of action. By comparing the existing notional return on the property with an IRR-assisted estimation of what the investment might return one year from now, the investor can make an educated decision about whether or not to sell. The IRR calculation might reveal that in a year’s time the property will accumulate an additional $100K in returns, or it might predict hardly any increase at all. In either case, it will be the IRR calculation that provides our investor with the insight necessary to make the right choice.
Now let’s look at a separate example using more or less the same figures to uncover another potential application of IRR for real estate investors.
Let’s say that this time our investor is considering purchasing a property as an investment, and after factoring in maintenance costs and property taxes, the total value of the investment after one year will equal $2M. This time, our investor knows what the property is currently worth, but wants to figure out what the property might be worth one year from now. Again, our investor can consult the IRR formula to obtain the estimation.
Now let’s take this second example a step further, and perhaps even make it a bit more realistic. Let’s say the $2M that our investor might use toward the purchase of the property is currently held in a mutual fund. When this is the case, our investor’s question will change dramatically. It will no longer be “is this property a good investment,” but rather “is this property a good investment versus alternative uses of capital?” And yet again we can see how our investor might utilize the IRR formula to compare the projected returns from the property investment against the existing and projected returns associated with the mutual fund.
While all of the above examples portray slightly different applications of IRR in real estate investing, they all speak to the same overarching benefit of using the formula, which is to determine, based on all available information, whether a particular investment is a profitable use of capital.
While IRR has proven to be an invaluable measurement tool for real estate investors, it’s also important to understand that the results of an IRR calculation, as alluded to earlier, are merely estimations of what a return might be, and are necessarily based on a series of assumptions rather than certainties. IRR can be extremely useful for its relatively simple application, as well as its ability to factor in future cashflows with considerable accuracy, however there are a number of factors that go into real estate investing that the IRR formula has no objective way of taking into account.
For one thing, individual real estate investments have unique risk profiles, and even if an IRR calculation estimates significant returns, there is no guarantee that those returns will be realized. Average rental rates could take an unexpected dive, for example, or an investor might one day learn of previously undiscovered or undisclosed damages that have a negative impact on costs. In short, there will almost always be variables that are outside of an investor’s control, and these need to be taken into account before relying solely on the projections of an IRR.
We also have to consider, as discussed in the last of our earlier examples, that just because an IRR is high does not necessarily mean that it is a good investment, or more specifically that it is a better investment than an alternative use of capital. Real estate investors will often need to consider the entirety of their investment portfolio to determine whether a project is worthwhile, rather than evaluating individual investments based on isolated IRR calculations.
All in all, IRR can be an incredibly helpful tool for guiding real estate investors toward more informed decisions. But as an estimation, it should also not be regarded as an infallible means for determining the overall favorability of a real estate investment.
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While IRR is often considered one of the most commonly used metrics for real estate investors, there are some other metrics used to help measure returns and the overall existing or potential benefits of an investment. And you will likely remember one of these from the IRR formula presented earlier: Net Present Value (NPV).
NPV is the most closely related metric to IRR, and is crucial to understand before an IRR can be calculated. In the most general sense, NPV is the difference between the present value of cash flowing in and the present value of cash flowing out over a specified timeframe and expressed as a percentage.
Once again, time is an integral component of the formula, and to help us understand NPV on a conceptual level, we can circle back to our earlier distinction between notional and realized returns. When calculating an NPV, the ultimate goal is to determine the present notional value of cashflow that an investor expects to receive in the future. If the NPV is positive, the investor can anticipate positive returns on the investment; if the NPV is negative, the investment will be viewed as unfavorable.
Of course, using NPV has similar limitations as using IRR, primarily that it also relies on certain assumptions about the future, or more specifically future cashflows, that could very well turn out to be false. Calculating NPV also requires the use of a discount rate, which is determined based on the initial capital needed to invest and what that capital might earn if used in an alternative investment. Again, the discount rate will be based only on an assumption about future returns, and could turn out to be inaccurate or misleading.
There are a number of other metrics used by real estate investors to evaluate existing or potential investments, many of which have specific applications depending on the unique business model or profit strategy of the investment. Some of these metrics include Vacancy Rate, Operating Expense Ratio (OER), and Gross Rent Multiplier (GRM), to name a few. Real estate investors should be careful only to consult the metrics that are most relevant to their unique ventures, and of course to remember that there are a variety of risks associated with real estate investments that may not be accounted for when performing an evaluation using these methods.
Are you interested in learning more about the ins and outs of investing in real estate? Whether you’re new to the investment world or looking to strengthen your existing knowledge, Yieldstreet has resources that can help. Check out our article on how to invest in commercial real estate for a basic rundown, or dive a little deeper with our guide to understanding the real estate capital stack.
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