Using The Internal Rate Of Return Metric For Real Estate Investments

A real estate asset’s internal rate of return (IRR) sounds simple enough to comprehend for those taking it at face value, but this metric is often misunderstood. Typically, investors will use an IRR calculator to determine the potential profitability of a future investment, but it’s capable of so much more.

When taken into proper consideration, and with a mind for due diligence, the IRR can help investors choose between assets that are dissimilar. In other words, a good internal rate of return calculator can compare “apples to oranges” when investors are choosing between two unique investment opportunities. Continue reading to learn more about the internal rate of return metric, and how you can potentially use it to your advantage with your investments.

Internal Rate Of Return (IRR) Defined

The internal rate of return is a metric used to determine the percentage rate earned on every dollar invested into a respective asset. Investors often use an IRR calculator to determine the profitability of a potential investment, and gauge whether or not to proceed with a deal.

Perhaps even more specifically, the IRR functions as a scale––one that allows investors to weigh the potential yield of one investment against another. An asset’s IRR may be used to compare its projected rate of growth to different investments of varying types. The IRR is, therefore, most useful to investors when they need to compare unique investment opportunities. More often than not, the deal with the larger IRR will win out, as it coincides with more potential.

That said, there are caveats in the internal rate of return metric that must be accounted for, not the least of which will be discussed later. For now, it’s important to know that the internal rate of return should never be used alone; it should be used in conjunction with one more important metric: the net present value (NPV).

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IRR Vs Net Present Value

While they share some similarities, there are very important differences to account for between IRR and net present value. Each of these metrics are used primarily to evaluate capital expenditures; however, that’s where there similarities end. Whereas the IRR is intended to calculate a percentage rate of return on a given asset (a return that will result in a net present value of zero), the NPV discounts an asset’s expected cash flow, which will often identify a surpluses or loss.

Let’s take a closer look at some of the more notable differences between IRR and NPV:

• Outcome: Calculating an asset’s NPV will give the investor a dollar value that the project is expected to produce, whereas the IRR generates an asset’s potential return (in the form of a percentage).
• Purpose: NPV calculations are more practical for identifying an asset’s surpluses and losses, whereas the IRR will give an investor a better idea of where the expected cash flow will allow them to break even.
• Reasoning: Since the NPV awards investors with a dollar amount, it is often used as the primary reason they follow through with a deal. Instead of suggesting how much money will be made, the IRR provides investors with a percentage rate that can compare two dissimilar investments.

Internal Rate Of Return Advantages And Disadvantages

The internal rate of return is a great way to forecast a project’s rate of return, but it’s just that: a forecast. The Internal rate of return is by no means guaranteed, nor should investors ever assume it is; it is nearly a projection of what an investor may be able to expect. As such, the IRR can be misleading if used incorrectly. More importantly, there are several advantages and disadvantage one needs to consider by implementing this equation themselves:

Internal Rate Of Return Advantages

• The IRR gives investors an idea of the return they can expect on the original investment.
• Expressed as a percentage, the IRR can help investors compare two unique assets and their potential rate of return. Typically, the asset with the higher IRR has more potential.
• The IRR is a relatively accurate way to determine an investment’s breakeven point.
• The IRR takes account of the time value of money. The timing of future cash flow is factored into the equation.
• The IRR is a relatively simple calculation.

Internal Rate Of Return Disadvantages

• At times, it can give you conflicting answers when compared to NPV for mutually exclusive projects.
• When used to compare two projects, the IRR does not account for each project’s size. Therefore, IRR is best used when comparing to similarly sized projects.
• The IRR does not account for future costs, and only concerns itself with projected cash flows.
• The IRR does not account for different reinvestment rates. It makes the assumption (often incorrectly) that the profits can be reinvested at the same rate as the internal rate of return.

Summary

The internal rate of return is a metric best utilized by those looking to compare two unique assets. Expressed as a percentage rate, the IRR can help determine the rate of return between two dissimilar projects overtime, and help investors choose which might suit their needs the best. Keep in mind the caveats associated with the internal rate of return, and be sure to utilize it amongst other calculations, including the net present value (NPV). Investors with a good understanding of the IRR can use it to their advantage and profit.

Key Takeaways

• An asset’s internal rate of return will give investors a good idea of how much their initial investment is expected to grow, or decrease.
• Understanding how to calculate internal rate of return could help investors choose between two different investments.
• Internal rate of return advantages and disadvantages are something to consider before following through with the calculation.