Investors use a number of different formulas to determine the value or potential upside of a particular real estate investment. 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.
If you bought a $100,000 property, then 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. That being said, 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 basically assumes inflation will mean that $1 today will be worth more than $1 several years from now. So, rather than simply 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/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?
As discussed in the opening section, IRR is a formula that can take a number of different factors into account when projecting the potential annual returns on investment real estate. Obviously, 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 (e.g. 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 any hope of returning money to its investors on an annual basis.
So, at the end of the day, the 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 at all. 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 to real estate investors.
Hire an Accountant
Imagine looking at 2 different properties in 2 different cities as investments. In order to really compare them side by side, you will need as comprehensive an IRR projection as possible. If you get it wrong on 1, or both of them, you could easily walk yourself into a financial nightmare that will leave you short on capital and 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:
- Property taxes
- Owner distributions
- Vacancy loss
- Capital improvements
In order to get an accurate IRR projection, all 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
By any standard, IRR is a complicated metric that weighs what can seem like a near-endless list of factors in order 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 more simple way of earning passive income through real estate, or at least leave IRR projections to professionals. 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:
- Best ForAccredited Investors
Must be accredited investing a minimum of $25,000.
- Best ForBeginner real estate investors
- Best ForNon-accredited Investors
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- Best ForCommercial Real Estate Investors
IRR: What Does it All Mean?
Everyone has heard the old saying that there is more than 1 way to skin a cat. It’s certainly got some truth behind it, and when it comes to real estate, there is more than 1 way to size up an investment. IRR is just one of those methods, but it is not foolproof. Even the best IRR predictions from the most successful investors are subject to go sideways.
With that said, having a properly figured IRR can go a long way towards giving investors a glimpse into both the present and future of a given investment. IRR is not everyone’s favorite measuring stick; and it’s almost certainly not something a novice investor should try to calculate themselves. However, understanding what IRR is and how it works will allow you to make more informed decisions about real estate investments.
Frequently Asked Questions
IRR is shorthand for internal rate of return. It is a percentage measure of how much money a property will earn for its investors on an annual basis in relation to its purchase price (or NPV). So, for example, a property that costs $100,000 with no financing and generates $10,000 per year in rental income has an IRR of 10%.
A good IRR is one that exceeds the annual cost of operating the property with all expenses calculated. So, for example, if a $100,000 property has annual expenses (e.g., maintenance, management, vacancy loss, insurance, mortgage) of $28,000, a good IRR would be something above 28%.
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