What Is Internal Rate of Return (IRR)

Investors use a number of different formulas to determine the value or potential upside of particular real estate investments. Perhaps the most common of these formulas is known as return on investment (ROI). To figure out the ROI on a property, subtract the purchase price of a property and all related expenses from the sale price when the property is sold. Then divide the profit by the original purchase price.

For instance, if you bought a $100,000 property and spent $15,000 on renovations and agent commissions before selling it for $150,000, your profit would be $35,000, which creates an ROI of 35%. While ROI might be the most common method, investors use another formula, known as internal rate of return (IRR) to get a more detailed view of a property’s earning potential.

What is IRR?

IRR is a formula that measures how much money a property can potentially earn or has earned on an annual basis in relation to its purchase price. Like ROI, IRR is calculated as a percentage. However, the IRR formula takes more variables into account than the ROI formula, which is why some investors believe IRR is a better metric for predicting the returns on rental income or investment property. Many investors and analysts shy away from IRR as a metric because it takes so many factors into account that calculating IRR is unwieldy, complicated and difficult to explain.

How Does IRR Work?

At its core, IRR is meant to allow investors to hedge against inflation by weighing the predicted or realized annual returns of a piece of investment property against its acquisition cost. IRR assumes inflation will mean that $1 today will be worth more than $1 several years from now. Rather than projecting ROI, the IRR gives investors an idea of what kind of money they can expect a project to generate annually for the life of the investment.

When it comes to a property that’s being financed, the idea is to generate an IRR that exceeds the cost of financing it — the annual percentage rate (APR). So, for example, investors want the IRR of a rental property with a $100,000 mortgage and a 10% APR to exceed $10,000 per year in annual income. That means the property will at least pay for itself based on its net present value (NPV) or original purchase price.

At a minimum, an investment property’s IRR should be equivalent to the annual cost of financing it. If a property’s projected IRR is lower than the APR for the loan, that means investors will be coming out of pocket to sustain it, which makes it an unattractive investment.

How Does IRR Apply to Real Estate?

IRR is a formula that can take a number of different factors into account when projecting the potential annual returns on investment real estate. The first hurdle a potential investment must clear is to have an IRR that covers the interest rate. However, when it comes to income property, the mortgage and APR are just a few of the expenses that need to be factored into an IRR equation.

Once the loan is covered, the cost of property management, maintenance and other professional services (agent commissions, accounting, legal fees) must still be factored in. Additionally, if there are ownership distributions to be made from rental revenue, they must also be included in the IRR formula. Once you add 6% annually for management, plus a 10% allowance for maintenance to the 10% due on the mortgage, a property may need an IRR of over 30% to have a hope of returning money to its investors on an annual basis.

IRR tries to take a holistic view of a property’s revenue potential as opposed to just assuming the property will appreciate and generate an ROI for investors when it is sold at some point in the future. The truth is, the property may not make any money at all, which would mean no ROI. So, at a minimum, investors will want to know that they will be breaking even on the expenses while they are holding it. That’s why proper IRR calculations can be such a valuable tool for real estate investors.

Hire an Accountant

Imagine looking at two different properties in two cities as investments. To really compare them side by side, you need as comprehensive an IRR projection as possible. If you get it wrong, you could easily walk yourself into a financial nightmare that will leave you short on capital and with a depreciating asset that you can only get rid of at a loss.

There is an almost endless list of potential expenses that can come with owning and operating an investment property. These expenses include:

• Mortgage
• Insurance
• Property taxes
• Owner distributions
• Vacancy loss
• Capital improvements

To get an accurate IRR projection, these expenses must be taken into account and weighed against the cost of each property. That’s why most savvy investors enlist the services of an experienced accountant to help them calculate IRR.

Benzinga’s Best Real Estate Investment Platforms

IRR is a complicated metric that weighs what can seem like a near-endless list of factors to paint a clear picture of a property’s earning potential. That’s why so few real estate professionals use it. It’s also why someone who is new to investment real estate might want to start with a simpler way of earning passive income through real estate. If you’d like to invest in real estate but would prefer to let someone more experienced than you do the heavy math that comes with IRR projections, perhaps you should take a look at this list of Benzinga’s best online real estate investment platforms below.

IRR: What Does it All Mean?

When it comes to real estate, there’s more than one way to size up an investment. IRR is one of those methods, but it is not foolproof. Even the best IRR predictions from the most successful investors can go sideways.

Having a properly figured IRR can go a long way toward giving investors a glimpse into the present and future of a given investment. IRR is not everyone’s favorite measuring stick, and it’s not something a novice investor should try to calculate themselves. However, understanding what IRR is and how it works can allow you to make more informed decisions about real estate investments.

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