IRR, or Internal Rate of Return, shows an investor what the likely average rate of return per year looks like over the lifetime of their investment. The equation itself can easily make one’s head spin, but we are here to break down these steps to make it more understandable with our guide to calculating IRR for your rental.
What Exactly Is IRR?
The internal rate of investment is often used in commercial real estate. It tells the investor approximately what percentage they’ll earn on every dollar they spend on the investment, over a specific period of time. To put it simply, money is needed to invest. As a commercial property owner, it’s helpful to know how that money will grow.
Why Is IRR Necessary?
Using the IRR formula gives an investor an idea of whether or not their investment is worth hanging onto or purchasing in the first place. IRR is a bit of a guessing game since nothing is concrete, but it still works quite well. Without it, there are too many assumptions about the return on investment. The goal is for the value of NPV to reach zero. In that case, the investor expects a profit and can therefore move forward with the investment. When neutral, they can expect no profit or ROI, but also no loss.
If you aren’t a mathematical genius, the IRR formula looks intimidating. Thankfully, plugging it into Excel does the work for us. Still, it helps to put it into words so see we can “see” how it works. Let’s break the formula down and make it understandable.
- NPV: The net present value (NPV) equals the current value of the flow of cash coming in and going out for a certain time period.
- N: Often representing the total number of years, “N” in the equation represents the number of periods during the evaluated time.
- Cn: The cash flow for the period at a certain point in the formula.
- r: The answer we are looking for — “r” represents the IRR (the value the equation is solving).
- n: The period representing that step of the formula.
As mentioned, technology solves IRR for us. Still, understanding how to calculate IRR for your rental is necessary for plugging in the correct numbers.
Looking at examples of IRR helps us visualize why it’s useful and how it works. Let’s take a look at a couple of IRR examples:
- Bob buys a commercial property. He then estimates all his costs for the property for the next two years. Using a few different interest rates, Bob works on calculating the NPV (net present value). He tries 6%, then 8%, then 7%, in hopes of getting as close to zero as possible.
- Let’s say at 6% he gets an NPV of $2000. That’s not near zero, so now he tries 8% and gets an NPV of -$1600. A negative number puts him below zero, at a loss, so now he tries 7%. This time the NPV is calculated at $15. That’s pretty close to zero, and as close as he’ll get, so he sticks with 7% and an NPV of $15.
Basically, to get the net present value, we are adding what’s coming in and subtracting what’s going out. The problem is, future money holds a different value and must be considered at today’s value, because current money is always more valuable than money that is expected later. So, calculating any present amount, then adding and subtracting, gets us the net present value. Here’s an example for that, using 10% to keep things simple:
- $2000 today earns $2000 x 10% = $200 in a year’s time
- That $2000 becomes $2200 in a year. But right now, it’s still $2000. The $2200 is a prediction of its value in the future.
- $2200 in the future is only worth $2000 today.
IRR Has Limitations
It seems fairly cut and dry; calculate the amount of cash going in compared to the cash going out over the lifetime of a property to determine future cashflow. However, it’s not as simple as it sounds. There are a fair number of assumptions and educated guesses that must go into the calculations.
So, although calculating NPV gives us an idea of the future, investors are limited with the IRR as far as 100% accuracy. Using it with conservative predictions may underestimate the future cashflow, while over predicting may upset the future with an ROI that doesn’t come through as expected.
IRR Is Not the Same as ROI
IRR and ROI are often confused within the real estate investment world. Let’s take a look at the differences.
ROI, or return on investment, measures how the investment cost compares to the profit. In other words, after investing a dollar amount, how much will the investment earn? The investment cost subtracted from the profit gives us our ROI. Understanding the return on investment tells an investor how efficient the investment is. As a rental property owner, ROI measures the efficiency of your rental investment and helps in comparing multiple property investments as a portfolio grows. ROI is best when the current cashflow value is needed.
IRR, or internal rate of return, is basically giving us the same information as an ROI, but in a more complicated way because we are seeking future value (TVM, time value of money). ROI is best when seeking future cashflow value.
Using both IRR and ROI together is helpful when seeking as much information as possible about the efficiency of real estate rental property. ROI is much simpler to calculate, but doesn’t account for the future, while IRR helps in predicting the future but is not completely accurate since assumptions are made during calculations.
Real estate investing is a great choice for income and wealth today and in the future. Although no predictive formula is foolproof, calculating IRR is the best option for understanding how the ROI and efficiency of your rental property will fair in the future.
Our goal at Excalibur Homes is to help real estate investors fulfill their real estate investment needs. We were voted “Best in Georgia” for a reason…that reason being the trust we’ve earned from our satisfied clients. At Excalibur, we understand the importance of your real estate investments. We’re proud to be the well-respected professionals in property management and buying and selling services for Atlanta investment properties, and the properties of all surrounding areas. Contact us and let’s discuss how Excalibur Homes can partner with you for your real estate investment needs.