A Guide to Internal Rate of Return & Other Must-Know Financial Metrics

by | BiggerPockets.com

There are a plethora of different calculations that can be used to evaluate a potential or completed real estate deal. This article will review those tools with a special interest in the Internal Rate of Return (IRR). When it comes to evaluating a real estate deal, or any investment for that matter, the most all-encompassing tool is the Internal Rate of Return. But like all calculations, IRR has its downsides. The biggest downside of the IRR is that in order to accurately calculate it, the deal must be done and over with. Not just the acquisition, but you must have sold the property, or at least refinanced out of your initial investment, in order to truly know what your IRR was. Otherwise, you have to estimate it on a set of assumptions and thus, it will be susceptible to the accuracy, or inaccuracy, of those assumptions.

Let us first look at some of the other common real estate calculations and their advantages and disadvantages.

Cap Rate: Net Operating Income / Total Cost of Property

The advantage of the cap rate is that it is easy to calculate. It also allows you to compare properties in a similar asset class with differing characteristics that make a direct comparison impossible. For example, say you are comparing two apartment complexes. One is a 100-unit apartment complex with 75 1-bedroom units and 25 2-bedroom units that average 750 square feet. Each unit has old, wooden windows, central air and heat, and the apartment complex has an onsite laundry room and a community swimming pool. The other is an 80-unit apartment complex with 20 1-bedroom units, 50 2-bedroom units and 10 3-bedroom units that average 900 square feet. Each unit has vinyl windows, washer/dryer hookups, but only a furnace. The air conditioning is achieved with window units. There in no swimming pool, but each tenant has a carport to park their car under.

Trying to compare such buildings is much more difficult than comparing two similar dwellings. Thus we have the cap rate, which takes the actual income those buildings produce minus the expenses, and then divides it by the total cost. This is a great tool for comparing such assets (as long as they are in a relatively similar class and area).

The disadvantage is that a cap rate is only a snap shot. It says nothing about the expected growth in rents, expenses, or property value. It also says nothing about whether using leverage will increase your return.

Related: Introduction to Internal Rate of Return (IRR)

Cash-on Cash-Return: Cash Flow / Total Cash Invested

Cash-on-cash return is also simple to calculate and tells you what your return will be in the first year of holding the property. This is a great calculation for investors who are intent on holding a property. It is also helpful when deciding whether to use leverage, and what kind of leverage, as you can easily calculate what kind of change your cash-on-cash will have when you reduce your cash invested by adding debt, and reduce your cash flow by the accompanying debt service.

Again, however, cash on cash is only a one year snapshot. It doesn’t take into account disposition or refinancing as well as changes to income or expenses that might alter your cash flow in the years to come.

Rent-to-Cost Yield: Monthly Rent / Total Cost of Property & Gross Yield: Total Cost of Property / Annual Rent

Both of these calculations are basically the same, just flipped around. I hear rent-to-cost used almost exclusively amongst normal investors, while I hear gross yield discussed amongst institutional investors. This calculation’s primary advantage is in how easy it is to calculate. On the other hand, there are so many variables left out (expenses, debt, etc.) that it should only be seen as a shorthand tool and not an in-depth analysis.

Gross Rent Multiplier: Gross Annual Rents / Total Cost of Property

Gross rent multiplier is very similar to the rent-to-cost or gross-yield calculation. It is easy to calculate and can be useful for quickly evaluating whether a property is worth looking at. However, it leaves to much out to be a satisfactory way to evaluate a potential investment in and of itself.

Return on Investment (ROI): (Gain on Investment – Cost of Investment) / Cost of Investment

Now we’re starting to get the whole picture. Return on investment and the internal rate of return act more like a film of the entire investment, while the above calculations are akin to pictures taken at the beginning. With regards to ROI, say you invested $100,000 and made $50,000 plus your principal, your ROI would be equal to ($150,000 – $100,000) / $100,000, or 50%.

That sounds like a good investment, but of course if it took you 50 years to make that kind of return, then not so much. You can get an annualized rate by simply dividing your ROI by the number of years you had the investment. In the above case it would be 50% / 50, which equals 1%.

Return on investment is beneficial for analyzing how well a deal did in the past. This type of measuring is always important, as you can’t fine tune your investing in the future unless you know how your investments have done in the past. Of course, when using ROI to analyze whether or not to buy a property, it’s only as good as your assumptions you put into it.

Related: Why I Only Pay As Much For Property As My IRR Allows Me

Internal Rate of Return

For the most precise evaluation of how an investment performed, we turn to the IRR. The definition of IRR is a bit technical, so I’ll let Ben Leybovich explain it: “For the other hard-core finance geeks out there, IRR is most specifically defined as the discount rate that makes an investment’s net present value (NPV) equal to 0.” Here’s the math from Wikipedia:

So now that everyone understands IRR, my job is done, have a great week everybody!

What, that explanation wasn’t sufficient? Fine, we’ll go into a bit more detail. As I explained in my previous article, IRR can be a very powerful calculation because it accounts for the fact that each year can have a different cash flow, and that the sooner money is earned, the more it is worth. Think about it this way, would you rather have $10,000 today or five years from now? Given that if you get the money now, you can invest that $10,000 and make a healthy return for five years, the correct answer is you would want the $10,000 now. Money now is worth more than money later.

So what the IRR is calculating is what your “annual effective compounded return rate” is, or in other words, what your average return is when taking into account when you have cash inflows and outflows.

Let’s say you are looking at a deal with the following assumptions:

  • Purchase Price and Costs to Close: $200,000
  • No Leverage
  • First Year Net Operating Income: $20,000
  • Annual Growth Rate of Net Operating Income: 2%
  • Year 5 Capital Improvements (new roofs, HVAC, etc.): $50,000
  • Disposition Price minus costs (end of year 10): $300,000

You can do this calculation in a spreadsheet using the formula =IRR() or you can use one of the many IRR calculators online, such as this one. Here’s what you get:

Your IRR equals 11.21%, before tax of course.

Now here’s why this is important. Let’s compare that to your Return on Investment. The total of your return is $468,994. So if we calculate the ROI, we get the following:

As you can see, the ROI is over 2% higher than the IRR. The reason for this is such a large chunk of the money came in at the end when the property was sold. As we noted above, money is worth more now than later, so your internal rate of return is reduced. The IRR accounts for when money comes in and out, whereas the ROI does not.

Also, as noted above, we can use IRR to evaluate what effect leverage will have on an investment. So let’s add debt to our equation:

  • $150,000 Loan (with $5000 loan fees)
  • So $55,000 total cash investment
  • $10,000 Annual Debt Service
  • You will have paid off $25,000 in principal on the note after 10 years (so your profit will be $300,000 – $125,000 = $175,000). You can figure out how much principal will be paid off by viewing an amortization schedule which you can find with any mortgage calculator, such as the one at Bankrate.com.

Then we run the numbers again. (Remember, your debt service doesn’t change, so the net operating income growth is more than 2 percent as the expanded table shows.)

As you can see, leverage almost doubles your IRR up to 20.15 percent. (The annual ROI skyrockets even more to 34.36 percent.) But of course, leverage makes everything more risky, so that needs to be taken into account as well.

Conclusion

IRR is a great tool to evaluate how well your investments have done and also find which types of investments (single family, multifamily, offices, etc.) or areas have been the most successful. However, in using it as a tool to predict the future, I must preach caution. There are plenty of websites and firms that will offer forecasting, and while I’m fully in favor of using those servies, I would always warn against relying on them. Make sure to use very cautious and conservative assumptions for appreciation of rents and the property’s value, especially if you intend to use financing.

But that being said, it is crucial to value properties before you acquire them. It’s also imperative to evaluate how you did during (and after) you’ve either sold or refinanced. Only by doing this can you both reduce the risk of making a mistake while fine tuning your investment and evaluation criteria. Math only sucks when you can’t make money using it.

What else do you want to know about IRR?

Ask me your questions in the comments below!

About Author

Andrew Syrios

Andrew Syrios is a real estate investor in Kansas City and a partner in Stewardship Properties along with his brother and father. Their company owns just over 500 units in four states.

7 Comments

  1. Llewelyn A.

    Awesome Article Andrew!

    The IRR is really the calculation that every Real Estate Investor needs to understand as much as they can.

    Not only that, but because you are making a decision on what will be the Return on the Investment over a 10 year period as if it’s a Compounded Rate of Return, one can build into the calculations some assumptions like:
    1) Annual Rental Increases
    2) Annual Expense Increases
    3) Average Appreciation Rate

    With 3) Average Appreciation Rate, you will then be able to determine the future Sales Price. However, since we need to Future Sales Proceeds, not just the Sales Price, we need to also calculate the Mortgage Balance at the end of the 10 year period.

    One can get VERY accurate on these calculations if the numbers are conservative.

    The only problem I see is that there are so many Investors that are not disciplined and motivated enough to learn these calculations that if they actually spent the time trying to learn it, they would not be Investing.

    I have Experience teaching RE Investors from the basics to the IRR and the drop out rate was probably 90%.

    While I consider this calculation to be the best Calculation you can have and can be used to compare ALL Investments, such as Stocks, Real Estate, Bit Coins, CDs, Treasury Bonds, etc to each other so that you can decide which is the best investment, I realize that 90% of most aspiring Investors will just not be able to accomplish getting as far as being able to complete an example or even understand that the IRR is basically the equivalent of pretending to put your Money into a Certificate of Deposit for 10 years and spitting out an Annual Fixed Interested Rate on that CD for ANY Investment.

    I sort of gave up teaching it because of the vast drop out rate and I didn’t want aspiring Investors to quit REI because they didn’t know how to do it. So I just try to ask people to at least consider adding the IRR to their Investor Toolbox.

    One thing you will not see on the Best Seller’s list of books to buy as a Real Estate Investor is a book about complicated Math like the IRR. There are several out there and one that I recommend is a book called “What Every Real Estate Investor Needs to know about Cash Flow” by Frank Gallinelli. The reality is that the majority of Investors have a difficult time with complicated spreadsheet functions like PV, NPV, IRR, DCF, etc. I don’t blame them as most have been out of school for years if not decades.

    So I am hoping that your article does become well received. All professional Investors need to know the IRR and I’m sure a lot of them don’t, but should.

    Thanks for your Article!

  2. Darin Anderson

    This is all great stuff and the IRR is well describe. Unfortunately the ROI that it is compared to here is too simple and as such ends up showing larger returns than the IRR when it should show smaller returns.

    The reason for this is that the ROI shown here ignores compounding and calculates the returns as if they are simple interest. As such it is not an annualized return. Namely it assumes a 5% return for 10 years would result in a 50% return. The problem with that investments aren’t calculated and compared that way so it leads to a misleading comparison to other investments such as stocks, bonds, CDs, or other real estate, or even to the IRR. For instance if someone invests in a 10 year CD that pays all the interest at the end (which they often do if you leave the interest to compound) and you got 50% more back than you put in, no investor is going to consider that a 5% return CD, nor is it going to be reported as having an APY of 5% when it is actually a 4.15% APY CD due to compounding.

    The annualized ROI should actually under-estimate the returns instead of over-estimate because it ignores the cash flow that is removed from the investment early. IRR is better of course because it accounts for both compounding and cash flow that is removed early (or extra funds that had to be put in during the middle).

    To annualize the return and account for compounding an exponential formula needs to be used rather than a simple division by number of years. Investopedia describes the formula to annualize returns here:

    https://www.investopedia.com/terms/a/annualized-total-return.asp

    In this example, since we have returns of 134.5% over 10 years that is a return of 1.345 times over and above the original amount. Thus we need to use this formula (1 + return) ^ (1/n) – 1 where n is the number of years. Thus we have (1 + 1.345) ^ (1/10) – 1. This yields an annualized ROI of 8.90%

    We can verify this by taking that return (1.089) and raising it to the power of 10 and multiplying it back by the 200,000 investment and we will get back to the 469K of the original investment. A 13.45% return over 10 years would turn a 200K investment into 700K so that number is far too high to report as an annualized ROI.

    The IRR actually captures the value of the early withdrawal of cash flow that the ROI misses and thus shows the investment to give better returns of 11.21% than just the annualized ROI shows at 8.90% If the reverse were true and the investment was cash flow negative and needed to be fed every month then the IRR would show a lower return than the ROI because it would be capturing the money being fed in early and ROI would miss the fact that the money came in early rather than just at the end.

    • Phl Olinger

      Thank you for posting the real math behind this article. I could make sense of everything above, but something felt like it was a bit off in the calculations. I am not a financial advisor, but I like math, and I simply use the rule of 72 for most of my calculations. (divide rate of return / 72 = number of years it takes to double your investment.) I appreciate your adding to the article. I guess I could see it didn’t fit the rule of 72, and that meant my alarms went off. Simply using a 10% ROI, quickly I can see that in the last 2 years (9 and 10) the 400k would be 440k and 484k the following, that wasn’t 469K. I also realize that you reach 400k at the mark of year 7.2, so compounding still happens for the next 2.8 years.

  3. John McNaughton

    Is it common/typical to separate the initial cost into year 0, and if so can you explain why? I could see if the calculation were somehow dependent on the number of years in the year column, but I believe excel calculates based on the number of items in the array.

    If you looked at it as the first day of year 1, and therefore the first row of the first table would have a net of -$180,000. That would increase the IRR to about %13.

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