Every investment decision begins with a simple calculation: risk versus reward.
That said, it’s difficult to know exactly how your investments will pan out through the twists and turns that inevitably happen in life. All sorts of unexpected circumstances can affect stocks, currency, corporations, properties and other assets—causing them to sink or surge in value.
Investors don’t have to feel their way in the dark, however. There are plenty of calculators, formulas and metrics available to help people make wise decisions about where to put their money. Setting aside a little time for research and number crunching can create an approximate forecast of performance and minimize risk.
This due diligence is especially handy when you’re trying to estimate returns or choose between several investment options that seem similar on the surface.
Rental property buyers have a number of metrics to gauge future earnings, including cash on cash return and cap rate, to name a few.
Internal Rate of Return - another important valuation formula - produces a slightly longer-term view than other real estate calculators. This tool takes into account a number of additional factors that can give you a more complete understanding of how your capital will grow.
What Is IRR?
Internal Rate of Return is the total interest earned on the money you invest.
In theory, IRR measures an investment’s annual return throughout the entire property ownership time frame. Unlike cash on cash return, which measures returns in annual segments, IRR weighs total earnings from the day you purchase your rental property to the day you sell it.
Another way to understand IRR is by zeroing in on real estate’s two main income sources: rental income and appreciation. Regarding rental income, it’s not enough to just add up years of rent, because the rent money received in the first year of ownership earns interest across the 5, 10 or 20+ years you own the property, while the rent income earned in the final year of the investment only gains one year of interest.
You’ll need a slightly longer yardstick for this type of calculation.
IRR uses the Time Value of Money (TVM) concept to determine a property’s worth. The TVM—sometimes called “present discounted value” refers to the idea that a dollar today is worth more than a dollar in the future because of its earning potential over time. This concept is based on the core assumption that money is worth more the sooner you receive it.
Internal Rate of Return takes a comprehensive view of how rent income and appreciation income grow to reveal a property’s total lifetime value.
Why Is This Important to Investors?
Internal Rate of Return is a worthwhile step in your due diligence process. IRR’s benefits include:
- Clarity: IRR is a single percentage number that incorporates a number of different elements like incoming cash flow, outgoing cash flow, appreciation, and loan costs.
- Vision: For real estate investors who plan on holding properties for the long-term, IRR is an ideal measuring stick. Unlike formulas that consider only net operating income and property appreciation, IRR captures total gains over time.
- Timing: An IRR calculation not only helps select one property over another, it can also help the buyer decide how long to hold onto the property. The IRR might indicate more returns over a longer period of time.
IRR is also known as "economic rate of return" or "discounted cash flow rate of return." The reason it’s called "internal" is because it leaves out external factors like the cost of capital or inflation.
How Do You Calculate IRR?
Internal Rate of Return is linked to another real estate valuation concept, Net Present Value (NPV), which is the difference between incoming cash flow and outgoing cash flow during a period of time. Like IRR, NPV is also used to measure the worthiness of a property investment.
Ultimately, your IRR will differ from other real estate investment metrics in that the period of ownership and the cash flow are major ingredients in the final number.
Before you begin, try not to be intimidated by the IRR formula. It’s a little complicated and might bring up some unpleasant memories of college algebra. Also, solving this equation manually can take a little time.
It’s much easier to use a software program to determine IRR. Microsoft Excel, for example, has several built-in IRR calculators to make the process quick, simple, and accurate.
You calculate IRR by setting the NPV to zero and running the following equation:
N = The number of years the investment is held
CFn = Current cash flow at that stage in the formula
n = Current period at that stage in the formula
IRR = Internal rate of return
One of the IRR formula’s challenges is determining how long you’ll hold onto your property and estimating cash flow amounts across many years. Without a crystal ball, you’ll have to do your best guesswork, anticipating emergency repairs and other unforeseen expenses.
Here’s an example of IRR: You purchase a single family rental with $150,000. You intend to hold onto the property for five years. Cash flow for the five years, in order, is $35,000, $55,000, $47,000, $50,000, and $49,000.
In this case, your IRR formula would look like:
NPV=-150000 + 35000/(1+IRR)1 + 55000/(1+IRR)2 + 47000/(1+IRR)3 + 50000/(1+IRR)4 + 49000/(1+IRR)5 = 0
Running those numbers through the calculator, you’re left with an Internal Rate of Return of 16.574%.
Quick note: If you’re searching for rental homes on Roofstock, we’ve already done the legwork for you: On every listing, we include a percentage point called “Annualized Return,” which is essentially the property’s Internal Rate of Return number. In that same module we also provide helpful metrics like cap rate, gross yield, cash flow, and appreciation.
What’s a Good IRR?
What constitutes a good Internal Rate of Return is a debatable topic among investors, and also varies based on whether the property is commercial real estate or residential real estate.
While many look to avoid single digit percentages, others argue that a very high IRR could result from a miscalculation of rent increases and appreciation — a staggeringly high IRR result might have come from a gross overestimation of rent increases and appreciation.
One easy way to judge your IRR is by figuring out your required annual return or cost of capital. This is your cost of debt and equity combined that will go into the investment, and it’s a good benchmark to weigh against your IRR. In other words, you’ll want your returns to be higher than your costs.
For example, you have two rental properties to choose from. After running the numbers on both, Home #1 results in a 10% IRR while Home #2 comes in at 11%. Those numbers are so close, it would be easy to go either way.
However, your cost of capital is 10%, making the decision an easy one: Pass on Home #1 because it would result in 0% profit.
The Internal Rate of Return calculation is not foolproof. As mentioned above, it does not take into account “external” factors like inflation and cost of capital.
Here are a few other IRR limitations to note:
- Inadequate Comparisons: IRR works when comparing investments of similar length; i.e. two single family rentals you plan on holding for ten years each. It doesn’t work so well when comparing investments with different timeframes.
For example, a two-year investment might return a 20% IRR while a comparable one at 10 years has a 10% IRR. You might go with the 20% option not taking into account that the 10% investment will gradually deliver more overall value across 10 years.
- Big Assumptions: IRR depends on a number of unpredictable factors. Your calculation won’t take into account market fluctuations, debt and project costs, rent prices, and so on. A little guesswork is better than nothing, but your IRR will be based largely on assumptions rather than facts.
- Bumps in the Road: Every property owner is aware that unexpected repairs and damages are inevitable parts of every real estate endeavor. Vacancy periods and slower rent increases can also curb expected cash flow. Your Internal Rate of Return number will be omitting all of those unknowns.
When it comes down to it, no investment calculator can predict the future and there will always be risk. Yet, when you’re ready to dive into the housing market, formulas like IRR —along with other helpful tools like cash on cash return, ROI and cap rate — can help you make an educated decision between several properties.
Speaking of tools...
Can we help make your job easier when it comes to evaluating potential rental property investments?
Roofstock Cloudhouse is a free tool offering comprehensive insight into a home’s rental potential. Simply enter the address of any single-family home in the U.S., and in one click you’ll get a complete forecast of the property’s potential return. This essential tool allows you to view cash flow, cap rate, home appreciation, and yield.