Internal Rate of Return (IRR): Understanding this Popular Return
by James Kobzeff
Internal rate of return (IRR) is generally more popular than other rates of return to a real estate investor because it calculates for time value of money and provides a linkage between present value (PV) and future value (FV) of any benefit stream.
As such, IRR allows the investor to take into account both the timing and the scale of cash flows generated by the income-producing investment property.
The principal assumption, of course, is that a dollar in hand today is preferable to a dollar at the end of the year or ten years from now. IRR measures future cash flows with a particular discount rate (an investors desired rate of return) and determines what that is worth today.
Unfortunately, trying to calculate IRR manually is not very practical for income property investors (or anyone else) because the internal rate of return calculation involves tedious mathematical solutions that take a lot time.
Even the most skilled investment real estate specialist probably wouldn't know the internal rate of return formula and instead would use a time value calculator or real estate software program to compute it. So we'll ignore the actual formula and instead resort to a simple example to give you the idea.
Example. Let's suppose you have $100,000 to invest in a rental income property and plan to hold it for five years and during that period of years you plan on receiving five annual cash flows along with an amount of additional money from the sale of the property.
The internal rate of return (IRR) becomes that unique rate at which the sum of those future cash flows are discounted to equal the initial investment of $100,000.
In other words, at what rate (which IRR establishes) must all future incomes be discounted so that the present value of all those future incomes exactly equal the amount of money initially invested.
So You Know
ProAPOD® Rental Property Investment Software computes internal rate of return automatically as you enter the property data. It is recalculated each time you make changes and instantly posted on the appropriate reports. Learn more at www.proapod.com
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