In real estate, it’s all about balancing risks against potent rewards to make a profitable investment. A cap rate calculation for real estate can give you a figure of your potential earnings for a period. However, IRR is a more useful metric in this regard. But what is IRR in real estate?
The Internal rate of return (IRR) is a precise measure of a property’s output in the long term. An IRR approximates a future investment's value with its current value. This metric is closely related to NPV (net present value). IRR’s a discount rate that is calculated yearly and makes NPV zero.
In this article, we will discuss what is an IRR in real estate alongside its pros-cons and calculation method. Besides, we will look into other related terms as well. Keep reading to explore more.
What Is IRR In Real Estate?
The term IRR (internal rate of return) is used to financially analyze the estimation of how profitable a potential investment will be. It’s among the numerous metrics investors use to evaluate real estate risk.
An IRR compares a future investment's value with its current dollar value. This metric has a close relation with NPV (net present value).
We can find NPV for a certain period by calculating the gap between cash gains’ present value and cash losses’ present value. It shares the same profitability determination goal and comparable uses as IRR.
Negative NPV investments will cost you money, while positive NPV investments will make you money. It is necessary to determine the market value of a property before you can calculate the NPV.
Next, you must calculate the total cost of the property's purchase, renovation, and operation. A total cost lower than the market price will result in a positive NPV.
Conversely, IRR is a discount rate. In analyzing a discounted cash flow, IRR turns every cash flow’s NPV to zero.
It’s important to remember that IRR doesn’t symbolize the project’s exact dollar value. It’s a return that is calculated annually and makes NPV zero.
Usually, a high IRR makes an investment more lucrative to embark on when considering other similar options. Because IRR is uniform for various types of investments, we can use it to index numerous prospective investments or schemes reasonably evenly.
However, if the IRR is lower than a business’s required RoR (rate of return), they are unlikely to move on with the investment.
How Does IRR Work in Real Estate?
Several real estate investors prefer IRR over the rate of investment (ROI) due to the inclusion of several factors in IRR. In figuring out IRR, an investor makes an ROI estimation after accounting for cash flow projections and the money’s time value.
When there are multiple options to choose from, investors might first check each option’s IRR. Afterward, they may choose the one with the highest IRR.
IRRs help real estate investors understand their investment’s future worth by showing its present worth.
It is important to remember that calculating a real estate investment's IRR is not like looking into a crystal ball and predicting its future.
Future projections of cash flows heavily impact IRR calculations. And several external factors can affect such projection with no prior prediction.
How Do I Calculate IRR?
IRR calculation follows the following formula
Ct = Net cash inflow in time t
C0 = Total costs of initial investment
t = Time periods
Let’s look at the considerations
- You can find IRR from the above equation by putting NPV = 0 and then solving it.
- As an outflow, the initial investment is never positive.
- Every succeeding cash flow could be above or below zero hanging on future capital injection requirements.
- As you can assume from the formula, the analytical calculation of IRR is difficult. Hence, it requires iteration through T&E or using a financial calculator.
- Spreadsheet software (e.g., Sheets, Excel) has built-in calculators to simplify things.
Why Calculating IRR Is Useful
IRR provides a more accurate estimate of the profitability of a real estate investment. It is not like the capitalization rate.
You can see the type of returns you’ll get from the investment from start to end when you use IRR. Conversely, capitalization rate calculation only examines the property’s NOI (net operating income) and purchase price.
Hence, IRR can be beneficial if you plan on making long-term real estate investments.
What Is a Good IRR for Real Estate?
In terms of IRR, there is no set figure that is regarded as good. So you can’t just straightforwardly give an answer to what is a good IRR in real estate. Accordingly, it depends on the project type, size, and investor's preference.
Positive IRRs indicate a profitable investment; negative IRRs indicate a loss. Real estate's 18% or 20% IRR is typically considered fantastic.
Investors should review their investment prospects if their IRR is low (below 5%). Usually, a high IRR (above 10%) indicates success, whereas a low IRR indicates failure.
However, IRR is not always better when it's higher. A 10-year investment with a 15% IRR might perform better than a 1-year investment with a 20% IRR.
IRR is usually more useful for cash flow assessment than ROI over the long run. Short-term accumulation of more wealth can be alluring, but long-term stretching of less wealth may be more effective in building wealth.
IRR vs ROI In Real Estate
An IRR reflects the money’s time value when calculating a yearly growth rate.
Regarding ROI, it calculates the growth rate from the start until the end of the acquisition period without considering income received along the way.
Some other notable differences between these two metrics include:
- ROI does not consider the number of returns and their timing, but IRR does. For instance, receiving $240,000 in year eight differs from getting $30,000 annually for eight years.
- IRR calculation is complicated and variable-dependent. Conversely, it’s easy for ROI, but you have to sacrifice the consideration of invested money’s future value.
Benefits of IRR
Let’s look at some of the benefits of IRR regarding real estate
- The IRR is calculated by considering all future cash flows and is based on the money’s time flow, giving equal weight to each cash flow.
- It’s an easy task to calculate IRR. Moreover, IRR compares the value of multiple projects very simply.
- Once the IRR calculation is done, you can select projects where it exceeds the estimated capital cost.
Disadvantages of IRR
IRR is not an unmixed blessing. Hence, it has some cons as well. Let’s check them out
- When comparing projects, IRR doesn’t take project size into account. Capital outlays, and cash flows are only compared.
- It overlooks the probable future costs that could negatively affect profit by focusing solely on the hurled cash flows from the capital injection.
- Cash flow calculation is part of IRR's job, but it assumes that reinvestment of cash flows at the exact rate is possible.
IRR can be an excellent metric for evaluating real estate risk. And our article will give you a better answer to “What does IRR mean in real estate?”.
However, taking advice from a financial advisor can help you big time in safeguarding your finances and choosing the best investment route. But there are numerous organizations out there. Which one will you choose?
Don’t worry, as Excelsior Real Estate is here to help. No matter what real estate investment you aim to make, our experts can advise you promptly. We will guide you on the path toward the most profitable one. Contact us today, and let us be a part of your journey.