What is IRR in Real Estate?
What is IRR in Real Estate?
Internal rate of return (IRR) takes the phrase “time is money” and really puts it to the test. When you invest in real estate, it’s important to understand what IRR, as well as net present value (NPV), means for your potential returns.
What is IRR?
Looking at the internal rate of return (IRR) is an effective way to get an idea of the profitability of an investment opportunity. In simple terms, the IRR is a metric that explains the expected compound annual rate of return that investors can earn from a project. Instead of looking at how much the projects return regarding absolute money, IRR expresses return as a percentage.
It can be a tricky calculation, and there are plenty of technical guides you can read about to calculate IRR and learn about applying investment approaches in response to the calculation. Stepping back from it, here are some of the most important things you need to know about IRR when you’re making an investment.
What’s the NPV?
To understand IRR, you first need to understand NPV, which stands for net present value. The NPV looks at the overall profitability across the lifetime of an investment. Put simply, if the NPV is positive, this means the investment will generate a positive return, and if it’s negative, the return on investment will also be negative.
Calculating the NPV considers cash flow, the investment period, and the discount rate, which an investor would expect to get on an alternative investment that holds equal risk to the one being evaluated. A higher discount rate leads to a lower NPV. The way to think about this is by considering the time value of money. Money that’s here and available today is worth more than the same amount of money in the future because money today comes with earning potential.
To put it another way, higher discount rates come with riskier investments that yield higher returns, but this also lowers the NPV of the deal.
So how do you calculate IRR?
By calculating the IRR, you’re figuring out the discount rate that would make the NPV of the investment rate equal to zero. Working the IRR formula by hand requires a lot of trial and error. It’s known as an incalculable number because you’ve got to work backward and figure it out through trial and error. However, Excel has an IRR calculator that cycles through rapid-fire equations to find the discount rate that allows the NPV to equal zero.
What do real estate investors need to know when it comes to IRR and NPV?
What’s more important for real estate investors to know is what certain terms mean when they see them on deal presentations.
A positive NPV means that the investment is projected to generate a profit. A higher IRR means the return is expected to be greater compared to lower IRRs. However, this number can also mean the investment is riskier. Consider this alongside your risk appetite and other aspects of the investment.
The IRR also considers the timing of projected cash flows and payouts. Investments that generate early cash flows have higher IRRs compared to investments that spread these payments over longer periods of time. This is because early cashflows have higher present values.
Here’s an example: If a 5-year investment has an IRR of 10%, it’s expected to produce an annual return of 10%. Knowing the IRR can help you decide if you want to commit your money to that investment for the time the deal will take.
IRR is usually close to the Annual Rate of Return (ARR). However, IRR considers the exact timing and frequency of cash flow. The faster the returns in a period of investment time, the higher the IRR value and the closer it is to the average.
When you see investments promoting ARR much higher than IRR, it is an indication of a very late payday!
IRR, in short, removes the time dimension from every investment. Because of this, you can compare projects as “apples to apples,” even if the time frame and total returns are different.
If you have any questions about IRR, NPV, or what it’s like to invest in real estate with Investream, chat with us today!
