Why IRR is Important for Real Estate Investors

Why IRR is Important for Real Estate Investors

July 20, 2022

Why is IRR important?

One of the essential real estate metrics investors should understand is Internal Rate of Return (IRR). IRR estimates the average annual return-on-investment over time. It looks at a property’s cash flows over the years of ownership, the time value of money, and the opportunity cost of having your money tied up in the property. Using these variables, IRR will estimate the return you can expect from a real estate investment over its lifetime.

IRR is one of the few metrics that projects potential earnings and accounts for both the cashflow you can expect to earn, as well as the appreciation gained from selling a property. This combination allows you to compare the expected return not just to other properties, but also to returns you could expect in other investment classes, like stocks. Calculating the IRR is difficult, as you’ll see later, but Padvest is here to help.  

How do Real Estate Investors Use IRR?

IRR represents the potential annual growth rate over the holding period of a property, and higher IRR will mean a higher chance of positive returns. The main benefit of IRR is to account for the changes in cash flows over time. If you are considering a deal that has improvements that need to be made over time, or some expected variability in cash flows, IRR can provide a more accurate estimate of the return over time.

Like other metrics, IRR should not be used as the sole indicator of a deal you are evaluating. Cap rate is useful for a quick initial analysis of a deal, but it may not be as accurate as IRR since it will not account for expenses over time or debt service. IRR is a valuable metric for considering the impact of time on the full term of an investment.

How to Calculate IRR

Calculating the IRR is complicated, and most investors use Excel instead of calculating IRR by hand. IRR is calculated by equating the sum of the net present values of future cash flows minus the initial investment to zero and solving for IRR. It accounts for the cash flow for each year, and the total appreciation over the entire holding period to calculate the return over time. Padvest’s property evaluation report will calculate IRR for you, and it uses a 30-year period of ownership.  

The way IRR accounts for time is by using each year’s estimated cash flow and then calculating potential returns over the remaining years. The IRR formula will look at the income during the first year and calculate the interest earned on that income for the next 29 years, then for year two it will calculate the interest for the next 28 years, etc. If you factor in changes in annual cash flows – things like first year improvements and annual rent inflation - this will mean cash flows are different year over year.  

The IRR calculation also accounts for appreciation of the property as part of the total return. For example, if you buy the property for $500,000 and sell it for $625,000, the IRR will include this gain.

All the gains - from annual cash flows, and sale proceeds - earned over the entire 30 years will be represented by the IRR.

Finding IRR For Your Real Estate Deal

Using Padvest, finding a potential deal’s IRR is easy. The Padvest property evaluation report calculates all the projected annual cash flow details including maintenance expenses, rent increases, and property appreciation. It uses those estimates to calculate the IRR – along with other key metrics - to provide a comprehensive analysis of rental properties you’re considering. Get started with Padvest to research your next deal today.