Do you really need IRR or NPV in rental property investing?

Question

I have been looking into IRR and NPV and I am hearing mixed reviews about both of them so I was wondering if you really need either of these two formulas or is one better than the other?

Dennis McNeely · Answer

Hmmm...

To calculate the interest earned by an investment of $25 per month at 5% interest per year where you make a year's worth of payments, you take the first payment and add one month's interest to it ($25 x 5% x 1/12). Next month, add that amount to the second month's payment ($25 x 5% x 1/12 + $50 x 5% x 1/12), and so on. In the end, you'll have some amount of money - your principal payments plus the interest they earned over the course of a year - a total of $306.97.

The NPV is just the opposite. Let's say you're promised a single lump sum equal to that amount ($306.97) in one year's time in an IOU at 5% interest. Now you want to know what that IOU is worth today. A financial calculator would indicate it's worth $292.03. Stated differently, the IOU for $292.03 today is equivalent to the string of 12 monthly payments of $25 if both earn 5% interest for a year. That's its Net Present Value.

The IRR is just a way to run the IOU calculation backward. If you receive 12 monthly payments of $25 and in the end you have $306.97 in your pocket, what interest rate did you earn? That same financial calculator will indicate you killed it, earning 5% on that string of 12 payments.

Different investors swear by different criteria, whether it's IRR (and the closely related NPV), cash on cash, the debt coverage service ratio (DSCR), the CAP rate for a property, or some other metric. Find one you like and run with it, but become familiar with the lingo so you're able to converse with someone else that uses a different favorite flavor of investment criteria when they're evaluating deals.

Hopefully I didn't just muddy the waters - or make your head explode!

Lane Kawaoka · Answer

IRR is the Internal Rate of Return can often get confused with the return on investment and cash on cash because over the period of one year, all these percentages are the same. IRR specifically takes the time value of money and calculates what the average return is over a period of time and annualizes it. Say you put that 10k in and made 7% per year for 5 years and compounded it each year that equate to a 7% IRR for those 5 years precluded that your 10k was returned to you at the end of the period. When looking at real estate we know that very seldomly does an asset perfectly return an exact percentage and typically the asset grows in value over the time period. This calculation can take that expected growth and growth in cash flows combined into one metric to look at the investment.

Personally, I don't really look at IRR because it is a highly manipulated metric.  Showing an unrealistic refinance in year 2 instead of year 3-4 will likely turn a 13% IRR deal to 16-17%. Magic! The best way to explaining this is for you to download an IRR calculator spreadsheet or build your own simple one and play around with one.

For what its worth most deals I deem meeting minimal IRR standards is 13-15% but you have to dig a little deeper to uncover the real placements of cashflows and capitalization events... and then dig even deeper to verify the assumptions such as occupancy, rent increases per year, and what reversion cap rate was used.

Again I don't look for IRR cause its manipulated a lot instead I look at total return on a 5 year basis. Its like sampling a NFL players 40 yard dash but for apartment underwriting. I'm sure there are other ways to do it but weather its right or wrong... I try to be consistent and I'm just trying to go in and pick the best in the field.

BP article - https://www.biggerpockets.com/member-blogs/7810/95294-what-i...

Immanuel Sibero · Answer

I see IRR frequently used in real estate but not NPV. IRR is more of a performance metric and NPV is more of a valuation metric. When it comes to real estate valuation, COMPS, PPU (price per unit), capitalization rate are some of the more common valuation metrics I see used in real estate as opposed to NPV.When it comes to performance metrics in real estate (of which IRR is one), I agree there are numerous and it can be confusing as to when to use which. I'm a relative newbie and went through this and found it helpful to first understand what each metric is designed to measure in the first place before deciding which one is needed for my analysis. Below is a quick summary:

Generally, the four sources of return in rental real estate are:
1- Cash flow
2- Loan paydown
3- Appreciation in value
4- Tax savings
Examples of performance metrics and what they are designed to measure:
- CoC (Cash on Cash) is a measure of net return generated by TWO sources (i.e. Cash flow and Loan paydown) on an annual basis.

- Equity Multiple (ROI) can be used to measure the net return generated by ALL FOUR sources (i.e. Cashflow, Loan paydown, Appreciation, and Tax savings) throughout the life of the investment. Equity Multiple does NOT take into account the time value of money. In practice, the effect of tax savings is usually not included because it can be complicated to calculate.

- IRR (Internal Rate of Return) can be used to measure the net return generated by ALL FOUR sources (i.e. Cashflow, Loan paydown, Appreciation, and Tax savings) throughout the life of the investment. IRR takes into account the time value of money. In practice, the effect of tax savings is usually not included because it can be complicated to calculate.

Cheers... Immanuel

Chris Seveney · Answer

@Martin Brown

Also the reality is if you are trying to forecast numbers, the second you hit enter they are wrong as nothing goes the way you modeled it.

The important thing to consider when modeling is to have data as accurate as possible (garbage in garbage out), but most importantly (and this is where investors miss the boat), what is the sensitivity to the numbers

For example if doing a flip with hard money, which causes more pain - $20k more to complete, 25k less in sales price or getting the right number but it takes 3 months longer?

Allan C. · Answer

@Peyton LaBarbera you can be profitable in real estate without using either formulas, but you can’t be a sophisticated investor without using at least IRR.

If you plan to buy cheap low cost properties and primarily seek cash flow, then you can use simple ROI/CoC formulas. If you get into more complex investment strategies where cash flows are not evenly distributed, then you’ll need IRR.

Chris Seveney · Answer

@Peyton LaBarbera

Where IRar comes in useful is when comparing two assets or two different investments.

Another way to look at it also is if you have a rental and you can increase rent by $100 and sell it in a year for a certain value, are you better off selling it today at another value or holding it for another year and collecting income?

what will give you a better return?

Another example is if you have a rental that is cash flowing, do you keep that rental? Do you buy assets based off of the financial data on that other asset.

Peyton LaBarbera · Answer

Couldn't agree more with you @Dennis McNeely! I am starting to understand that if you use too many formulas you just might never find a deal, since all will be gone by the time your done calculating ;)

Thank you for all of that great info!

Peyton LaBarbera · Answer

Ok great! I was looking at those two formulas and thinking to myself this seems a bit excessive for rental property investing, thanks @Bjorn Ahlblad!

Bjorn Ahlblad · Answer

ROI gives me everything I need and I understand the process. Less complicated, you don't need to be a SW engineer.

Do you really need IRR or NPV in rental property investing?

Most Popular Reply