How Internal Rate of Return Benefits Real Estate Investors
The Internal Rate of Return is just one of many rates of return real estate investors use to help them measure the profitability of potential real estate investment opportunities.
What makes it generally more popular than most, however, is that the internal rate of return (IRR) accounts for time value of money. Therefore it provides investors with a linkage between both the present value (PV) and the future value (FV) of a rental income property's income stream.
The idea is straightforward. Given that the investor is making an investment with money that has a particular buying power today, IRR enables investors to determine their rate of return on their initial cash investment based on what a property's estimated future cash flows are also worth today.
The internal rate of return becomes that unique rate "at which all tomorrow's incomes are discounted to exactly equal the amount of money initially invested today". In other words, the discount rate is what we call the internal rate of return.
How to Compute
Trying to manually make the calculation would require a good deal of time. But the good news is that there are a couple of ways you can compute IRR short of being a mathematical wizard.
- A hand-held financial calculator like HP12. In this case just open the instruction manual, read along and make the necessary keyboard selections.
- MS Excel. Open the spreadsheet and select one column to enter the initial cash investment (make it a negative number), enter the future cash flows in concurrent fields below it with the sales proceeds added to the last, then select a separate field and use the IRR function to complete the calculation.
- iCalculator. Simply open the IRR calculator in my online real estate calculator and complete the form.
Rule of Thumb
By itself the internal rate of return is not enough to sign on the dotted line. There are many other factors to consider like economic and market area trends, financing, structural condition and location, income tax implications, as well as a host of other prudent real estate investing due-diligence practices.
Moreover, one-size doesn't fit all. Whereas one investor might find some rate of return appealing, another might have no interest whatsoever. It depends on the investor's particular objective and how it might stack up to other investment opportunities available. But you get the idea.
So You Know
ProAPOD's real estate investing software solutions (Agent 6 and Executive 10) and it's suite of online real estate calculators (iCalculator) each compute the internal rate of return.