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The IRR, or internal rate of return, is a commonly used return metric in real estate. It is especially useful when analyzing an investment’s profitability in relation with time. Traditionally, a real estate investor holds a property for multiple years, with the initial equity invested plus appreciation returned at the time of sale. Given the real estate investor could have invested in something more liquid (can enter or exit the investment at any time), such as a stock, real estate investors care about the investment’s return on a yearly basis. Don’t worry, this will make sense as we continue. Mathematically, the IRR is a discount rate that makes the net present value of all cash flows in an investment equal to zero. If that didn’t put you to sleep, let me explain why it’s more important to understand its fundamentals than it is to understand that textbook definition.
Essentially, the internal rate of return (IRR) is the percentage earned on each dollar invested through each period it was invested for. So… say you have a house you purchased for $100,000, and you wanted to achieve a 10% IRR on a 5-year hold without renting it to tenants. To solve for that sale price in year 5 that would get you that 10% IRR, multiply that $100,000 by 110% (10% return) for Year 1, now multiply that new number of $110,000 by 110% again for Year 2, then again for Year 3, through year 5. It would look like this:
Year 1: $100,000 x 110% = $110,000
Year 2: $110,000 x 110% = $121,000
Year 3: $121,000 x 110% = $133,100
Year 4: $133,100 x 110% = $146,410
Year 5: $146,410 x 110% = $161,051
So, you are not just achieving a 10% IRR in 5 years by achieving a 10% return on your initial investment… no… you are achieving a 10% each year of your investment on that new value you have achieved at a 10% return on the previous year. That is what is known as compounding, and it is what determines your IRR. Utilizing cash flow and appreciation, as we discussed in that blog, those two value drivers will determine your return each year and subsequent IRR for your investment period.
Similarly, think about if you were to buy $100k of a stock January 1 of one year, and on December 31st of that same year, you sold it for $109k. The return over the year would be 9%. While we do not exit our real estate investment in the example until year 5, in the long run, the yearly return is better than the 9% achieved in selling your stock.
Okay, here is the IRR formula:
To be completely honest, I didn’t even try to remember that and just copy/pasted from Google. Good to see, not essential to remember. Why? Well… thank our lucky stars for Excel (and you too, Microsoft). Excel has two IRR functions (IRR and XIRR) that will roll up your investment’s cashflows over a certain period and spit out an IRR. Just so you know, the IRR Excel function is to be used if you are tracking your cashflows on an annual basis, and XIRR will help with other periods (monthly, for example).
Think of IRR as the rate of growth year-over-year that an investment is expected to generate during your ownership. In reality, an investment will usually not have the same rate of return each year (or other period), similar to how an average taken from a sample doesn’t represent each part of the group – it serves as a summation. Usually, the actual rate of return that a given investment ends up generating will differ from its estimated IRR. This is because if it wasn’t already tough enough to predict an investment’s cashflows, you also have to be able to predict when those cashflows will happen!
Now that we have set the foundation and have shown what the appreciation factor does, let’s look at how cash flow contributes. So say you buy the same home from before for $100,000, and you are hoping to achieve a 10% IRR over 5 years, but will sell at $100,000 and will rely on cash flow. It would look like this:
Year Start Cashflow Year End
Year 1: $100,000 + $10,000 = $110,000
Year 2: $110,000 + $11,000 = $121,000
Year 3: $121,000 + $12,100 = $133,100
Year 4: $133,100 + $13,310 = $146,410
Year 5: $146,410 + $14,641 = $161,051
Different means to the same end as the appreciation example. So when you combine cash flow and appreciation, you can boost that IRR on two fronts. Operations vs capital markets! See, real estate can be fun.
Let me be frank with you, you could spend time learning about the science of the IRR and even memorizing the “IRR Tables” so you can impress someone by being able to mentally estimate IRRs for complex investments (and will make you a better investor, sure)… but at the end of the day, the conceptualization provided here combined with trusty Excel are enough to make you dangerous on the topic. It is an important metric to analyze your investment because it provides solid relativity to other investments, such as stocks, and it can give you a sense of what might make a better investment on paper (barring several other factors and risks). Hope you enjoyed this read, and feel free to reach out with any questions!