Real Estate Returns | Internal Rate Of Return, IRR in Real Estate
What Is Internal Rate of Return? What Is IRR?
The Internal Rate of Return, also known as the discounted cash flow return, is a single discount rate that summarizes the return of an investment property given a price and the future cash flows the investment property will generate.
The IRR is helpful because it allows us to calculate the return of an investment over multiple periods. We also typically have the information to calculate it since all we need is a price and series of Pro Forma Cash Flow statements for the holding period of the investment. As long as the cash flows are conventional, it is a relatively simple tool to use to evaluate the return of a property.
Internal Rate Of Return. The IRR in Real Estate
What Is IRR? What Is Internal Rate Of Return?
The internal rate of return is a percentage rate that summarizes the return of a multi-period investment with multiple future cash flows. The IRR is useful to analyze and compare real estate investments. Real estate investments are highly diverse and the IRR allows the returns of multiple rental properties with different characteristics to be compared.
How Is The Internal Rate Of Return Calculated?
The IRR is calculated by determining a discount rate that yields a sum of zero when the present value of all current and future cash flows are netted against each other.
The cash flows may encompass the acquisition price, operating cash flows, and reversion cash flows. The reversion cash flow essentially represents the proceeds from the sale of the rental property at the end of the holding period.
For analysis or illustration, the IRR can be calculated up to any point in time or period during the holding period. It does not need to continue to the end of the holding period. It can sometimes be useful to illustrate how the IRR can vary through the life of an investment. For example, this can help determine the length of time to hold an asset to maximize the internal rate of return.
Cash outflows can be considered negative. Cash coming in can be considered positive. The present value of all these cash flows are totaled. The net sum of the present value of these cash flows is the Net Present Value. The trick of the IRR is that it finds the discount rate where the Net Present Value equals zero. This allows the formula to be solved for the discount rate which is the internal rate of return.
The Internal Rate Of Return Formula
The irr formula below is the Net Present Value (NPV) formula where the NPV is set to zero. The IRR is the discount rate. CF represents a cash flow at a point in time. The cash flow can be negative or positive. n is the number of the period at which the cash flow occurs.
To calculate IRR, the rate of return formula sets NPV to 0. With the known cash flows, the formula is solved for IRR. IRR is solved through iterative algorithms in computer software or financial calculators.
NPV = 0 = CF0 + CF1/(1 + IRR) + CF2/(1 + IRR) ^ 2 ... CFn / (1 + IRR) ^ n