In real estate investing, there’s no straightforward forward way to assess how a project is doing or might do. Because real estate is a private asset, it’s subject to vicissitudes and variables that, say, stocks are not. However, there is a metric that’s popular with real estate investors called internal rate of return, or IRR, that provides them with a solid way to check on an investment’s profitability or potential profitability. What is the internal rate of return? Let’s look.
Internal Rate of Return
Internal rate of return is essentially a tool that real estate investors utilize to evaluate profitability over time.
Another way to say it is that it’s a means of calculating an investment’s future value as if it were valued in today’s currency. Remember, $20 today is not valued as it was 20 years ago, nor will it be valued the same 20 years from now.
Therefore, to get a good idea of an investment’s risk, you calculate what a venture will be worth in the future and what it would be worth today — and compare it to what you’re investing.
How is IRR Calculated?
The IRR formula is rather involved and requires determining what’s known as the NPV, or net present value, which needs to be set to zero. Why? Because the internal rate of return is the discount rate for which an investment’s net present value is zero. There are other formulaic elements that include net cash inflow, total investment costs, required return, and discount rates.
But for practical purposes all you need is an IRR calculator, which, after inputting key details, will provide results in seconds.
Why is the IRR Important to Investors?
When an investor uses an internal rate of return, he or she is estimating the rate of return, but only after considering the investment’s likely cash flow and the time value of money.
Ultimately, the IRR gives investors a better understanding of a venture’s future value by showing what it’s worth now. They can also size up the potential for profitability against other investments such as stocks.
What are IRR’s Shortcomings?
No, it’s not a perfect tool; it’s certainly not a crystal ball. IRR determinations hinge significantly on projected future cash flows, which can be affected by a myriad of unpredictable external factors. For instance, an IRR calculation does not consider a project’s size or risk profile, the time frame for generating returns, or the specific amount of profit to be realized.
Note that IRR and the above-mentioned net present value are mere estimates, and ultimately, that’s how they should be treated. So, to get as true an IRR as possible, investors are advised to evaluate the validity of such assumptions before making an investment decision that is based exclusively on what the internal rate of return comes up with. In other words, don’t depend on IRR alone for your investment decisions.
What’s Deemed a Good Rate of Return?
You’ll see various answers to this, but most consider a “good” IRR as one that’s in the 20 percent or higher range. Some say that you need at least 25 percent. Generally, though, with all things being equal, a higher IRR is better than a lower one.
Now that you know what an internal rate of return is, you can add it to your arsenal of knowledge regarding real estate investing. If you’re new to the real estate world, or want to pad your knowledge, the alternative investment platform Yieldstreet offers a cache of resources that you’re free to use.
