Internal rate of return: in simple terms
The internal rate of return (or IRR) is generally one of the most popular rates of return used by real estate investors trying to measure the financial performance of a rental property because it calculates the value of money over time. Therefore, because it provides an association between the present value and future value of the income stream, it allows the investor to take into account both the timing and the scale of the cash flows generated by the income-producing investment property.
Okay, that’s a mouthful, but bear with me. This article will really try to explain what internal rate of return is in a way that you and I can better understand.
This is the idea. The IRR has to do with the rate of return the investor can expect on the capital invested in purchasing a rental property based on anticipated future income streams. That is, that future income divided by the initial investment equals the rate of return.
But in this case, instead of simply dividing the amount of those future income streams by the amount of the investment, the IRR applies a “discount rate” to calculate the “present value” of that future income before dividing it by the investment.
A simple illustration will help explain why this is important.
Let’s say you were given the option to collect $ 10,000 today or wait to collect it a year from now. What option would you take? Of course, you would take the $ 10,000 today because you no doubt understand that inflation erodes purchasing power over time and in a year, $ 10,000 will not buy you as many goods as you can buy with the same amount today.
The internal rate of return takes care of that same assumption and, as a result, considers the “present value” of projected income flows, not just projected (unadjusted) income flows. Let us consider another example.
Suppose that $ 100,000 is invested to buy a rental property that during one year produces a cash flow of $ 5,000, in addition, at the end of that same year the property is expected to be sold for a profit of $ 20,000; in other words, a projected future income totaling $ 25,000. However, instead of just dividing the $ 25,000 by $ 100,000, which in this case is 25.0%, the IRR first discounts that future income and then does the math. For example, at a discount rate of 10%, the present value of future income becomes $ 22,727, and when divided by the investment, you get a rate of return of 22.73%.
You see the difference? While the first method, without discounting future income streams, calculates a 25 percent return, the internal rate of return method, discounting future income, calculates a significantly lower return, and certainly one closer to reality. .
You can preview various reports created by the real estate investment software referenced in the resource box below that calculate this return.