Unlike the performance of investments such as stock as bonds, it’s just not that easy to assess the profitability, or potential profitability, of real estate investments. But one of the best ways to figure out how likely you are to get a good return on a property is to use what’s called the internal rate of return (IRR). Here’s what you need to know about using IRR to evaluate real estate investments – and more.
What is an IRR?
Essentially, an IRR is a metric that is used to gauge real estate over time, with the aim of evaluating profitability.
More specifically, an internal rate of return is a tool used to figure the future value of a real estate investment as if it were valued in today’s dollar. By figuring out what a property might be worth down the road, how much it would bring today, then sizing that up against the size of your investment, you can gain a good idea of what your risk might be. It’s not a perfect tool, but it’s likely the best one available.
Why is the IRR Popular with Real Estate Investors?
Real estate investors often prefer the IRR over return on investment (ROI) – a similar tool in real estate – because it includes multiple factors that ROI doesn’t. When calculating an investment’s IRR, the investor is approximating the rate of return. This, after considering the investment’s projected cash flow and the time value of money. Typically, the investment with the highest IRR is likely the one that will garner you the best return.
In the end, totaling up the internal rate of return for every potential real estate investment can give you a good idea of what its future value might be. How? By revealing what it’s worth now.
Can You Explain More About the IRR Calculation?
Basically, the IRR calculation melds profit and time into a single formula. But let’s define terms. Profit is the amount of cash the investment produces during the holding period. This is compared with how much capital is invested. Time value of money (TMV), meanwhile, approximates what the current value is of money that will be received in the future. The IRR also gives you what’s called the opportunity cost by lining up the IRR of each investment against alternatives.
So, in essence, the IRR is the discount or interest rate that renders the NPV – net present value – of the incoming cash flows equal to zero. By assigning a value to the periodic cash flows, the IRR facilitates a good comparison of alternative investments with cash flows that occur at disparate times. Why? Because the dollar you get today is worth more than the pledge of a dollar you’ll receive in the future. You simply can’t discount factors like inflation or some unforeseen future event.
When using IRR to calculate real estate investments, it’s important to note that the IRR doesn’t have crystal-ball insight into your project’s future value. After all, IRR calculations depend significantly on future cash flows, which can, in turn, depend on a myriad of unpredictable external factors.
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