Internal Rate of Return (IRR) is one of many returns real estate investors routinely use to measure the profitability of rental property.
In fact, rather than simply relying on an appraisal to determine investment value, real estate investors commonly rely on IRR before making any real estate investment decisions.
In this article, we will consider internal rate of return and why it has become such a popular return for those engaged in real estate investing activity.
Popularity
Time value of money consideration is the most predominate benefit investors derive from IRR. 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.
Here’s the idea behind time value.
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.
The beauty of IRR 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. In other words, it considers time value of money and states this relationship between scale and timing in mathematical terms.
So it’s a straightforward way for real estate investors to anticipate their return with time value consideration. And as a result, has become one of the more popular rates of return used by those engaged in real estate investing for their investment decisions.
Method
An investment can be defined as an expected stream of income.
When you make a real estate investment, for instance, 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.
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.
Example
Say you’re considering a cash investment of $100,000 to acquire a rental income property that you estimate will produce cash flows of 2000, 2100, and 2200 over three years along with cash proceeds of 120,000 from a sale in the third year.
Schema
- Year 0 Cash Investment
- Year 1 Cash Flow
- Year 2 Cash Flow
- Year 3 Cash Flow
- Year 3 Reversion
- Year 0 $100,000
- Year 1 $2,000
- Year 2 $2,100
- Year 3 $2,200
- Year 3 $120,000
Result
Based upon the scale and timing of the property’s anticipated future cash flows, you can anticipate that your initial cash investment will yield 8.2410% equal in today’s dollars, not on tomorrow’s dollars.
In other words, the sum total for each of the future cash flows discounted back at 8.2410% equals the amount of the initial cash investment.
So You Know
ProAPOD Real Estate Investment Software provides an INVESTOR 8 and EXECUTIVE 10 solution that each automatically calculate internal rate of return for inclusion in the appropriate reports.
