Internal Rate of Return in Terms We Can All Understand

The Internal Rate of Return is one of the most used and quoted terms in real estate investing. Yet, for most, it is the least understood investment measurement. In this article it is time to clear the air. Let's take a look at what this financial return is about and why it is so important in real estate investment analysis.

When calculating this rate of return for real estate investing, it is composed of three values; the initial equity investment, the net cash flows for each year and the appreciation from the sale of the property at the end of the holding period. This financial return is the discount rate applied to the future cash flow stream that makes the net present value (NPV) equal zero. That definition is as clear as mud to me, time to use terms that we can all understand.

You must understand that $1,000,000 today is more valuable to you now, then that same $1,000,000 five years from now. You can take the $1,000,000 today and invest it or spend it. But if you must wait 5 years before you get your hands on the money, that $1,000,000 does not hold the same value. Therefore, you need to know the future value of that $1,000,000 in today's value which is known in investing as the present value.

The formula for the present value (PV) is:

(Income Amount) / (( 1 + Discount Rate) raised to the power of the year)

Try this example, a 6 year investment with an initial investment of $1,000,000 with six years of positive cash flow of $200,000 each year at an 11% rate. How did I decide on an 11% rate? A discount rate is a subjective value. To determine your rate, use a rate that you would expect to earn on your investment. I am expecting an 11% return on my six-year investment of $1,000,000; therefore I will use an 11% rate.

Discount Rate = 11.00%

Net Present Value = -$153,892.43

Yearly Incomes

0 = -1,000,000

1 = 200,000.00

2 = 200,000.00

3 = 200,000.00

4 = 200,000.00

5 = 200,000.00

6 = 200,000.00

Yearly Present Values

0 = -1,000,000

1 = 180,180.18

2 = 162,324.49

3 = 146,238.28

4 = 131,746.19

5 = 118,690.27

6 = 106,928.17

Notice that as you advance in years, the present value decreases. The longer you have to wait, the value of that money decreases. Calculating the Net Present Value, or the sum of the cash flow stream, gives us a -$153,892.43. That 11% rate has given us a large negative number having a large NPV is not very appealing as an investment.

What if we worked backwards and wanted to know what discount rate would give a zero NPV. This returns us to the original definition of the Internal Rate of Return. A discount rate or return of approximately 5.47% would give us a NPV of $0.04. Four cents on a million dollar investment is very close to zero.

Discount Rate = 5.47179130%

Net Present Value = $0.04

Yearly Incomes

0 = -1,000,000

1 = 200,000.00

2 = 200,000.00

3 = 200,000.00

4 = 200,000.00

5 = 200,000.00

6 = 200,000.00

Yearly Present Values

0 = -1,000,000

1 = 189,624.16

2 = 179,786.61

3 = 170,459.43

4 = 161,616.62

5 = 153,231.62

6 = 145,282.08

Think of it this way, you invested $1,000,000 and plan to hold onto that investment for six years with a $200,000 yearly income. What rate can you use to balance your initial investment with those future incomes? That discounting rate is your internal rate of return. The Internal Rate Return is the balance between what you invested and the income you received, all factored by values in today's equivalent amounts.