Internal rate of return (IRR) is one of the most widely used tools in commercial real estate investing. While that market isn’t as simplistic as the stock market, which you can check with a quick call to your broker or with a couple of computer clicks, investors use IRR to help them navigate the intricacies of real estate and to make better investment decisions. Alas, while internal rate of return is generally helpful, there are factors IRR calculations can overlook. Let’s examine that – and more.
What Exactly is IRR?
Let’s begin here. Basically, internal rate of return is a means of determining an investment’s current performance or a prospective project’s likely return rate. In other words, the metric is the annual growth rate an investment is expected to produce.
How is IRR Calculated?
Expressed as a percentage, the IRR calculation is rather complicated, although there’s no practical concern since most investors use a special calculator for easy results. What’s key for you to know here is that there are two chief factors with which IRR is mainly concerned: profit and time. Simply put, the term “profits” refers to any earnings that total more than an investor’s initial investment, less costs including property taxes, ongoing maintenance, etc.
However, the “time” factor is not as straightforward when determining an internal rate of return. For instance, a property’s value is affected by factors such as housing trends. There is also the ever-changing value of money; we understand that $100 today has a different value than it did 10 years ago, just as it will have 10 years from now. Thus, the value of “profit” also changes.
So, it’s more accurate to say that investors utilize internal rate of return to gain a better understanding of an investment’s actual or potential profitability – in relationship to time.
How Useful is IRR?
As we say, while imprecise, IRR is a solid tool, if only because there are few alternatives available. And even those aren’t much better.
Where IRR shines is its ability to provide insights on prospective investments. IRR provides investors with educated assumptions about their investments’ probable performance. Moreover, IRR helps to evaluate the likely profitability of an investment as compared to others, or as compared to a different use of capital.
Where Does IRR Fall Short?
We’ve already alluded to some of these. Yes, there are external factors that IRR does not include (note that the term is “internal” rate of return). To wit, such calculations exclude factors including capital costs, inflation, financial risk, and risk-free rate.
There are risks inherent in every real estate investment, and simply because an IRR result points to significant returns, such predictions may or may not come true. For example, there may be previously uncovered property damages that can raise project costs. Or perhaps rental rates unexpectedly fall.
The general rule is that when using IRR to decide whether or where to invest, the higher the IRR, the better. However, a lofty IRR does not necessarily mean that the property would be a good investment or even a better investment than something else. So, investors would do well to consider their entire portfolio when sizing up a project’s worthiness – not simply isolated IRR results.
So, yes, there are factors internal rate of return calculations can overlook. Still, the metric serves its purpose in a market which offers few reliable alternatives, particularly if you are aware of, and can adjust to, its shortcomings.
If you wish to find out more about the world of real estate investing, consider contacting the alternative investment platform Yieldstreet, which has resources that can help.
