Rei acronym IRR? Internal rate return

19 Replies

newbie question

What is IRR?

How is it calculated? Do you guys use it?

Matt

IRR (Internal Rate of Return) is one financial metric that you can use to evaluate an investment. There is no blanketing formula for IRR because each industry uses different types of income. I have seen IRR used primarily in commercial real estate.

If you really want to understand and use IRR you need to understand NPV and have a good understanding of how to use a spreadsheet.

What type of real estate are you evaluating?

My initial google search has me wanting to know this number more.

It appears is like a cash on cash metric but goes on til exit. That is a calculation of multiples including exit sell price. It seems like a extremely complicated math formula but a needed number for true final analysis.

Originally posted by @Jared Anderson :
IRR (Internal Rate of Return) is one financial metric that you can use to evaluate an investment. There is no blanketing formula for IRR because each industry uses different types of income. I have seen IRR used primarily in commercial real estate.

Thanks Jared. This is for sfr buy and hold rentals.

Newbie here...what is net realizable value?

Here's a good summary

http://www.mathsisfun.com/money/internal-rate-return.html

Depending on your method of investing it can be difficult to use IRR for real estate. You will usually end up with negative net present cash flows if you don't factor in the selling price of the property at some future date, which is difficult to estimate.

I am not familiar with NRV. Investopedia.com always gives a good financial explanation of these types of terms. Here is a good link for how to calculate IRR. It even gives you how to build the formula. When looking at it remember your Year 0 is your initial investment and subsequent years are your cash flows.

thanks @tim butters

wow, this is a complicated one..I think I understand the definition and what it represents. It would be great if someone had an example for a buy and hold npv 100, 000. I am not going to stuck on it but I would like to be able to compare like I can with cap, coc...etc.

The formula is well defined. But, as Tim mentioned the IRR is not all that easy to calculate for real estate. And because of an ever increasing margin of error in estimating the ultimate sales price the farther out you go, it isn't all that meaningful either. In other words, you can make the IRR be just about anything you want it to be on the front end of a real estate transaction. Looking backward, it is very accurate and can be used to show just how optimistic your numbers where when you bought.

As a predictive tool, it is best used for things with an ultimate future value of zero, like the depreciating value of machinery or tools or the declining balance of a note.

My Penn State education has not sufficiently prepared me for IRR calculations:)

thanks guys plus @duncan taylor...I have a better understanding in five mins...you guys are smart!

I had to do IRR and NPV a bit in grad school. I think it's more important to know how to use and interpret vs. calculate it. Calculators/spreadsheets can calculate.

Here's my overly simplified explanation. NPV is a go/no-go decision tool. When NPV is positive, then you should theoretically be ok to move forward with a project.

NPV should consider the income and expense streams and be discounted or adjusted by a risk factor or required rate of return given the nature of the project. For example, a property in Detroit with the same ROI and cash flows should not be considered the same risk as a Note on a home in NYC. You might, for example, discount Detroit at 15% (required rate of return) vs. 8% in NYC.

IRR is useful for complex irregular cash flows over a significant period of time. If all the investment and income is made in year 1, then it's of no use. For a commercial property with payments/income years away, you would want to calculate your ROI as IRR (considering when expenses and income occurred). The adjustment factor considers the time value of money or cost of money, e.g. 6% interest rate on a loan. Risk is not considered in this calc.

I would argue NPV should be use a lot for residential analysis with a "portfolio" of risks to optimize returns so not all investments are in Detroit, nor are they all low margin, bread-and-butter investments either.

Rick

As others mentioned IRR measures the return on an investment over its complete life; purchase, operation and sale. It is used to compare projected returns on different investments or in the case of private equity to demonstrate that the projected returns are high enough to satisfy their investors.

There are whole threads on CRE forums about whether IRR or NPV is better for different types of real estate investments but the two are connected: The IRR (as a %) is the discount rate in a NPV calculation that returns a zero value.

I highly recommend reading Frank Gallinelli's book What Every Real Estate Investor Needs to Know About Cash Flow... And 36 Other Key Financial Measures to get a solid understanding of how to measure real estate returns. Frank is a member here and you can get his book on Amazon: http://amzn.to/Zv0Zph

Good hunting-

Don't worry much about IRR. It's mostly used looking back as a way to report returns. Important for syndications or funds because it lets investors compare returns to other asset classes. Also be careful with IRR because it makes some generous assumptions with reinvestment rates on the periodic cash flows. A modified IRR or MIRR can fix this.

Not saying that it's completely irrelevant to a small investor but there are other metrics that are more meaningful for an individual investor.

IRR is useful when you have an investment that requires irregular injections of cash or produces irregular returns. Simpler metrics, like cash on cash return, are more relevant to most real estate investments.

If someone's offering you an investment, and showing great returns based on an IRR calculation, beware. With some optimistic future assumptions it can produce impressive numbers.

Awesome imput guys..the more I know becomes the more I don't.

I checked out the Harvard, Stanford, and Princeton business school links on the matter.

It was interesting that they could predict with levels of certainty that health care and technology sectors were going to produce the best investment returns starting in 1990. Looking back, not a gamble, but in 1990 that was slightly unconventional thinking partially backed by IRR rational. This is a rate I will eventually start calculating for comparison purposes. Thanks again!

At my buy and hold rentals price point, my future values are zero in mathmatical terms. This irr number is critical for longterm purposes. Just saying, I need maximum confidence available for family expextations.

Here's an example of using IRR for a real estate return calculation:

IRR Example

Originally posted by @J Scott:
Here's an example of using IRR for a real estate return calculation:

IRR Example

Such an insightful blog. I thank you for that info. If you had two investment opportunities all being equal and one had concrete IRR and the other had no idea what IRR is, from business confidence perspective this could become a no brainer. I imagine guys/gals who know IRR have the investment advantage with superior analysis.

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All of the responses that have been made on the question so far are excellent and I couldn't agree more. In case you want some deeper knowledge on this particular metric and many others that are used in valuation, what has been a key resource for me and you may want to look into is the book "Mastering Real Estate Investment" by Frank Gallinelli. He makes it easy to understand with lots of examples to practice with so you can get a firm grasp on valuation metrics for Real Estate.    

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