If only assessing real estate performance were as cut-and-dried as it is with stocks and bonds, which only requires the click of a digital button or two. With real estate, things are not that straightforward. But that’s okay, because there’s a popular tool used in real estate called internal rate of return, or IRR. Let’s look at why IRR matters in real estate investing, and what you should know about it.
In the main, IRR is a tool that real estate investors use to evaluate real estate over time, with the goal of assessing profitability.
Digging a bit deeper, IRR is utilized to calculate the future value of a venture as if it were valued in today’s dollar. By calculating a project’s likely future worth as well as the amount it would bring today, then comparing that to the size of your investment, you can get a handle on what your risk might be.
Why Do Investors Use it?
It is true that there are several ways to assess current and future real estate investments. However, IRR is popular mostly because it factors in multiple variables that return on investment (ROI), another widely used tool, does not. What’s important to understand is that, when figuring out an investment’s IRR, investors are approximating its rate of return. And this is only after factoring in the property’s expected cash flow and what’s called the time value of money.
Ultimately, if the internal rate of return is totaled for each potential investment, you can gain a good idea of a property’s future value. That comes by calculating the property’s current value.
The IRR Calculation
The formula is a bit unwieldy, but keep in mind that you’ll either use an IRR calculator – which makes things easy – or someone will do the calculations for you.
In essence, the IRR calculation condenses “time” and “profit” into one formula. Each term requires elaboration. The time value of money approximates how much money to be received in the future is worth today. Profit, meanwhile, is how much money the investment generates during the holding period.
Another good thing about internal rate of return, by the way, is that is gives you the opportunity cost: which of your projects is your best bet.
When it comes down to it, the IRR is the discount rate that makes the net present value (NPV) of incoming cash flows tantamount to zero. Remember that today’s dollar is not worth what it did 20 years ago, nor is it worth what it will be 20 years from now. After all, there’s no anticipating possible factors such as inflation or some other unforeseen occurrence.
Is IRR Better Than Alternatives?
As we say, there are a dozen or so gauges that real estate investors can use. IRR is widely used more than, say, return on investment (ROI) because it factors in variables that ROI does not, including time value of money. TMV calculates the current value of capital that you’ll get down the road.
Ultimately, there is a trust factor among investors that if the IRR of a project is relatively high, particularly when put up against other projects, then that’s likely the one you should go with.
Now you know why IRR matters in real estate investing. Such investments are increasingly popular since people are looking at ways to generate passive income streams that are not directly tied to the stock market, where volatility is common. If you wish to learn more, consider contacting the alternative investment platform Yieldstreet.