What You Wanted to Know About Internal Rate of Return But Were Afraid to Ask
Real estate investment analysis requires more of a prudent real estate investor than simply using an appraisal (or market value) approach to determine the investment value of rental property.
Investing in real estate must also be studied from a time value of money standpoint because the timing of receipts from the investment might be more important than the amount received.
Why, because the longer you have to wait to collect your money, the less “present value” it has today, and in a time value of money sense, a dollar in the hand today is preferable to one at the end of the year or five years from now.
What makes internal rate of return (IRR) one of the more popular rates of return for real estate investment analysis and investment decisions is that it does account for the length of the anticipated holding period and factors for both, the scale of cash flows and their timing.
The internal rate of return model states this relationship in mathematical terms as a rate the real estate investor can in part use to accept or reject any investment based on that rate.
Okay, let’s look at how it works.
An investment can be defined as an expected stream of income. When you make a real estate investment, you invest cash in order to receive a series of future annual cash flows and a future cash flow reversion (cash you receive when you sell the property).
The challenge for real estate investors is to discover what rate of return the investor’s initial equity makes based upon those periodic future cash flows at the same time it considers the number of time periods (years) under consideration in the holding period.
Internal rate of return provides that rate.
To do this, the internal rate of return model creates a single discount rate whereby all future cash flows can be discounted until they equal the investor’s initial investment.
In simpler terms, internal rate of return reveals what a real estate investor’s initial cash investment will yield based on future cash flows discounted to equal today’s dollars, not tomorrow’s dollars.
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