Monitoring the performance of investments like stocks and bonds is relatively simple. On any given day, investors can log on to financial news websites, or their brokerage accounts, to see how their holdings have performed.

Real estate, however, is a private asset that doesn’t afford the same daily visibility into pricing and performance. Calculating a historical or expected return may therefore require more effort. In light of this, one of the most commonly accepted ways to gauge the profitability of a real estate investment is by calculating its Internal Rate of Return (IRR).

IRR: Internal Rate of Return

Internal Rate of Return (IRR) is a metric that tells investors the average annual return they have either realized or can expect to realize from a real estate investment over time, expressed as a percentage.

Example: The IRR for Project A is 12%. If I invest in Project A, I can expect an average annual return of 12%.

The basic idea behind IRR is to combine a measure of both profit and time into a single metric.

  • The concept of profit is relatively straightforward: how much cash an investment generates relative to the amount you invested.
  • The time value of money is a somewhat more complex concept: Inflation affects the value of money over time, meaning a dollar today is worth more than a dollar five years from now. For instance, $1 today may only have $0.90 of buying power in 2022.
  • Similarly, every investment has a trade-off, or opportunity cost. If you choose to invest in project A, it may mean that you are forgoing the opportunity to invest in project B. Or, if you receive a dollar today, you could invest that dollar and earn a return; but if you receive that dollar in the future instead of immediately, you are, in effect, missing out on potential return.

How real estate investors can use IRR

Over the life of a real estate investment, which typically lasts for at least a few years, investors receive a series of interim payments from renters, as well as a larger lump sum once a property is sold. Occasionally there may also be a refinancing or some other event that creates additional cash proceeds. Because these cash flows occur over many months or years, their relative value isn’t equal. As discussed above, a dollar today is worth more than a dollar five years from now.

IRR allows investors to derive an apples-to-apples comparison across investment opportunities by appropriately weighting cash flows that occur at different times.

It is important to note that for most real estate investments, the initial IRR is only an estimate based on a number of assumptions. However, it is still a valuable tool for measuring a project’s potential annualized return. Once the investment is sold, the actual final IRR can then be calculated.

Calculating IRR for commercial real estate investments

The goal of IRR is to provide investors with an expected return based on cash flows that vary over time. An IRR calculation levels those cash flows by expressing a single percentage: the annual rate at which the net present value (NPV) of those cash flows equals zero.

The mathematical formula for IRR therefore involves finding the discount rate, or interest rate, that sets all the project’s cash flows to an NPV of zero. A project with a positive IRR means investors have earned a return on their investment. A negative IRR implies a money-losing project.

Calculating IRR for real estate investments involves making a few assumptions:

  1. The level of annual distributions to investors.
  2. The date at which the project will be sold.
  3. The price at which the project is sold.

Each of these assumptions will then be measured in relation to the initial cost of the investment.

Example 1: Find the IRR of a five-year investment with no yearly distributions.

  • Assume the initial investment is $1,000.
  • Assume no cash flows are received over the five-year period.
  • Assume the initial $1,000 is recovered at the end of year five.

In this case, the IRR would be zero. That’s because no cash flows were received, and the initial investment was recouped after five years—the investment did not generate any additional profits.

Example 2: Find the IRR of a five-year investment with yearly distributions.

  • Assume the initial investment is $1,000.
  • Assume yearly distributions of $100 are received from the project.
  • Assume the initial $1,000 is recovered at the end of year five.

In this example, the IRR is 10%. That means that the investment generated an annualized profit of 10%.

Example 3: Find the IRR of a five-year investment with no yearly distributions.

  • Assume the initial investment is $1,000.
  • Assume no cash flows are received over the five-year period.
  • Assume the initial investment is sold for $1,610.

Here, the IRR is still 10% because the value of the investment appreciated from $1,000 to $1,610 (10% compounded annually) despite no cash flows being received in the interim.

For more varied cash flows, carrying out this calculation can be difficult, if not impossible, using just pen and paper. For that reason, most people use online calculators or spreadsheets to do the work for them.

Note: These examples are extreme oversimplifications. Actual cash flows from a project will typically involve varying amounts.

The shortfalls of using IRR in real estate investments

Using IRR for real estate investments has advantages: it considers the timing of future cash flows and weights them accordingly, and it can be relatively simple to calculate (particularly when using an IRR calculator).

But investors should not rely on IRR alone for guiding their investment decisions.[1]

Most importantly, a higher IRR doesn’t necessarily mean that a project is a better investment—many factors can determine a project’s return. For example, an IRR calculation doesn’t take into consideration the size or risk profile of a project, the time frame over which that return will be generated, or the actual dollar amount of profit to be realized. Real estate projects can also carry risks that can be difficult to accurately project, such as rental rates and occupancy.

Because IRR relies on such assumptions, projections from managers can sometimes misrepresent or mislead. Investors must therefore assess the validity of the underlying assumptions rather than making an investment decision based solely on the stated IRR.

Simply put, an IRR calculation is a projection and like any estimate, actual results can vary materially from expectations.

Consider additional metrics

Given the dynamics above, investors are encouraged to use IRR in conjunction with other metrics, such as the equity multiple. To calculate the equity multiple, an investor would divide the total cumulative cash flows they plan to receive over the life of the project by their initial investment. However, equity multiples don’t take the time value of money into account, which is where IRR is a helpful complement.

Applying IRR alongside other measures of return can help investors contextualize not only real estate opportunities, but virtually any investment offering. The end objective should be a better grasp of both past and potential returns across the investing spectrum.

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  1. McKinsey&Company, August 2004 ↩︎

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