Internal Rate of Return (IRR) 

When evaluating an investment property, using rental metrics and analytics is crucial for making informed decisions. Metrics provide a clear picture of a property’s current or potential financial performance, helping investors gauge profitability and mitigate risks. Internal rate of return (IRR) is one metric that can help investors optimize their portfolios, ensuring they make the most out of their real estate ventures. 

What is IRR? 

Internal rate of return, or IRR, is a metric commonly used by investors during capital budgeting to predict the long-term yield of an investment while accounting for the time value of money. It estimates a property’s profitability over the period you will own it, expressed as a percentage you could generate based on each individual dollar invested. 

Because IRR is a uniform investment metric, it can be used to compare multiple potential investments and make decisions about which ones to pursue. The property with the highest IRR can be considered the one with the most profit potential. 

IRR Formula 

IRR is rarely calculated by hand. Most investors interested in knowing their IRR will use an online IRR calculator or spreadsheet to quickly find IRRs for multiple properties. However, taking a quick look at the formula can help you better understand the required inputs (what you need to know before you can calculate IRR) as well as the output of the formula. 

Below is the IRR formula: 

\(0 = NPV = \sum_{t=1}^T \frac{C_t}{(1 + IRR)^t} – C_0\)

NPV = Net present value of the cash flows 

C sub t = Net cash inflow during t 

C sub 0 = Total initial investment costs 

t = # of time periods (e.g., 12) 

To understand this formula, it’s helpful to focus on the left half first: Net Present Value (NPV). NPV is the difference between the present value of cash inflows and outflows over a period of time. You’ll notice that the NPV is calculated using the right half of the formula above. If NPV is greater than zero (NPV > 0), the investment is expected to generate more cash than the initial investment amount. This would indicate a profitable investment, where net cash flow is positive. On the other hand, if NPV < 0, the investment is expected to generate less cash than its cost—not profitable. 

IRR is based on NPV. IRR is essentially a discount rate that makes the total value of the investment equal to zero. In other words, it’s the rate at which the NPV equals zero. That’s why the whole formula is set equal to zero above. 

Overall, IRR represents the annualized effective compounded return rate of a potential investment. It’s a powerful metric that many investors use to compare their projected cash flows in a slightly more sophisticated way than is possible with ROI. 

When to Use IRR 

The IRR calculation is best used for determining the future value of a real estate investment in comparison to other investments. It’s a helpful tool for making decisions and tipping the scale in one way or another when you aren’t sure what the investment performance will look like for all your options. Because IRR also accounts for the time value of money and other long-term factors relevant to future cash flows, it can give you a more accurate assessment of a property’s potential value in the future based on its value today. 

How to Use the IRR Calculator 

Using Innago’s IRR real estate calculator can save you time and effort when evaluating properties. Rather than grappling with the complex formula above, you can simply enter the following inputs to get an accurate estimate of your IRR. 

Inputs 

Below are the inputs you’ll need to use this IRR real estate calculator: 

1. Initial investment cost 
2. Number of time periods/months 
3. Net cash inflow 

Initial investment cost is the amount of money you initially invested in a property. This would be equivalent to the property’s purchase price if you paid in cash, or the down payment you made plus closing costs and any other upfront investments if you financed the purchase. 

The number of time periods/months is simply the number of “periods” the formula will iterate over, usually just ‘12’ for an annual analysis divided into monthly periods. 

Lastly, your net cash inflow is your investment return over one month (or the period you specified above). In other words, this would be the rental income your property generated over a month minus its expenses. It’s the difference between the property’s cash inflows and outflows. 

Outputs 

The IRR calculator will generate two outputs based on the above inputs you enter: 

• Interim cash flow analysis over each period 
• IRR (%) 

The interim cash flow analysis allows you to see your projected cash flow for each interim period of the whole (in the usual case, for each month of the year). The calculator will also generate your projected IRR, specified as a percentage.   

How to Interpret Your IRR 

What is a good IRR? 

Generally speaking, the higher the IRR, the more profitable the investment will be. However, whether a specific IRR is “good” or “bad” also depends on the other options you’re comparing, your individual goals as an investor, and your personal risk tolerance.  

For instance, let’s say you’re comparing two properties: Property A with an IRR of 27% and Property B with an IRR of 20%. It might seem like Property A is obviously the best choice, as it has the higher profit potential.  

However, let’s say Property A has a longer development timeline or needs major initial rehabbing before it can be operational. If you don’t have the experience or bandwidth to take on that large of a project, Property B might actually be the better choice from a holistic sense—despite the fact that you’ll be taking on slightly more risk and trading some profit potential for less time and effort. 

As you can see from the above example, IRR is just like any other real estate metric in that it should be considered in context. For the most complete understanding, it’s best to pair IRR with other informative metrics like ROI, cap rate, annual growth rate, and others. 

Conclusion 

Internal rate of return (IRR) is a powerful metric for real estate investors, offering a comprehensive view of an investment’s potential profitability over time. By understanding IRR, investors can make more informed decisions and compare multiple investment opportunities with greater confidence that positive cash flows will result. Using an IRR calculator online, like Innago’s, simplifies this complex calculation, saving time and ensuring accuracy for your planning.