Within the real estate investment world there are many methods for determining whether a potential deal or project is advantageous, disadvantageous or neutral, but perhaps the most referenced method is the Internal Rate of Return, or IRR. The definition of IRR is fairly straight forward and easy enough to find with a simple internet search or literature reference. Actually explaining IRR, however, is a slightly more complicated task because of it’s dependence on who is using it and for what purpose .
From the perspective of a corporation, the IRR may be used in the capital budgeting process. In this instance it is the discount rate applied that makes the net present value (NPV) of cash flows from a defined project equal to zero. Simply put, the IRR is the average annual return an investor can expect over a specified holding period based on projected cash flows. The actual mathematical formula for determining the IRR, while not overly complicated, is fairly tedious and not the purpose of this post. Most real estate professionals use a financial calculator, spreadsheet or software program to make the calculation.
More specifically, the IRR is often utilized within real estate because of how effectively the method applies the time value of money and thus, the value of the given investment. Simply stated a dollar in your pocket today is more preferable than a dollar in your pocket one year or three years or five years from now. For example, that dollar today can buy you a can of Coca-Cola, but that same dollar may not be enough to buy that same can of soda a year from today because of expected or realized inflation. Now this is key: just how much the price of that can of soda increases is unknown. This uncertainty must be accounted for in some fashion, which is the discount rate that must be applied to account for this uncertainty.
The internal rate of return works effectively within the real estate investment world because it provides the rate of return a real estate investment will yield based on expected future cash flow streams discounted to equal that initial investment. Therefore, if you were to invest $10,000 in a multi-family project with a five-year hold period and the IRR was 0.0%, this would mean that your investment would return the equivalent of $10,000 after 5 years. Remember, that can of Coke may cost $1 today, but in 5 years it may cost $1.20. Therefore, this would not be a good investment because you could simply put your money in a money market account and receive a better return than 0% and without the same amount of risk.
From an investor perspective, an IRR for an individual real estate project should be compared against prevailing rates of return in the securities market and other potential investment vehicles. When you make a real estate investment, you are investing cash in order to receive a series of future annual cash flows resulting from rental income, plus the back end profit (if any) when property is sold after the initial hold period. The question an investor should ask themselves when considering investing in a particular real estate deal is what is the rate of return that will make my initial investment worthwhile for the stated holding period? What is my comfort level? The assumptions that go into a particular project and the specifics of a particular property (e.g. market, competition, property type) all need to be accounted for within these assumptions. These assumptions will have a profound impact on the forecasted future cash flows. Therefore, it will be important for an investor to feel comfortable with the investment and to complete their own due diligence on a project to make sure the assumptions are reasonable.