Monitoring performance of investments like stocks is relatively simple. All you have to do is log on to a financial website or on to their brokerage accounts to see how your holdings have performed. However, things are a bit different when it comes to commercial real estate. Real estate is a private asset that doesn’t afford the same daily visibility into pricing and performance. Calculating expected returns or historical returns, therefore, requires extra efforts. This is where the Internal Rate of Return (IRR) comes in. IRR is used to gauge the profitability of a real estate investment.
What is the Internal Rate of Return (IRR)?
Internal Rate of Return (IRR) is a metric that investors can use to calculate the average annual return they have either realized or can expect to recognise from a real estate investment over time, expressed as a percentage.
The basic idea of IRR is to combine a measure of both time and profit into one metric
– The concept of profit is straightforward. The amount of more cash generated over the amount of money you invested.
– The time value of money is a bit more complicated. Inflation plays a significant role in determining the value of money. A dollar today may cost less or more five years down the line.
– Every investment has a trade-off or opportunity cost. If you choose to invest in Project A today, that means you’re forgoing the opportunity to invest in project B. Or, if you receive a dollar today, you can invest it and earn more. However, if you receive the same dollar later, you are effectively missing out on a potential return.
IRR in Real Estate Investment:
With IRR, investors can calculate expected returns based on cash flows that vary over time. IRR calculation levels those cash flows with a single percentage: the annual rate at which the net present value (NPV) of those cash flows equals zero.
The formula for IRR, therefore, involves finding the interest rate that sets all the project’s cash flow to an NPV of zero. A positive IRR means investors earned a return on their investment. A negative IRR means vice versa.
Calculating IRR involves making a few assumptions:
- The level of annual distributions to investors.
- The date at which the project will be sold.
- The price at which the project is sold.
Each assumption will be in relation to the initial cost of the investment
Example 1: IRR of a five-year investment with no yearly distributions
– An initial investment of $1000 is being assumed
– Assumed that no cash flows are received over the five year period
– It is believed that the initial investment amount is recovered at the end of the year
In this case, the IRR would be zero. That’s because no cash flows were received, and the initial investment was recouped after five years—the investment did not generate any additional profits.
Example 2: Find the IRR of a five-year investment with yearly distributions.
– Assume the initial investment is $1,000.
– Assume yearly distributions of $100 are received from the project.
– Assume the initial $1,000 is recovered at the end of year five.
In this example, the IRR is 10%. That means that the investment generated an annualized profit of 10%.
IRR can be handy into calculating the average annual return. If all of this confuses you, you can come up to us at Perfect Real Estate Investment and we can help you come in terms with all the numbers and figures and offer you the best deals. Hit us up for a consultation