Internal Rate of Return: How to Make the Calculation

Internal Rate of Return (IRR) is a rate of return commonly used by real estate investors when evaluating rental income property because it accounts for time value of money, and thus enables investors to calculate a rate of return on their initial cash investment based on what all future cash flows generated by the property (including the cash proceeds from a sale) are worth in "today's dollars".

What IRR Signifies

Simply put, the internal rate of return is that unique discount rate at which tomorrow's future cash flows are discounted until the total present value of those future values exactly equal the amount of money initially invested today.

For example, say the investor's initial cash investment is $500,000 and he or she wants to calculate the IRR based on the property's projected annual income stream for each of the next five years.

If each of those future annual incomes is discounted at (say) 6.29%, and their present value total equals $500,000, then that discount rate of 6,29% would in fact be the internal rate of return.

How to Calculate

Trying to manually calculate IRR requires lots of trial and error calculations that makes it practically impossible to resolve quickly, if resolve at all. The good news is that are a couple of ways for us to make the calculation with far less effort.

1. HP12 A hand-held financial calculator like Hewlett-Packard's HP12. The series of steps required to make the calculation using the HP12 are illustrated in the Hewlett-Packard Owner's Manual.

2. MS Excel To calculate IRR, on a blank spreadsheet designate one column to enter the following data (starting at the top and descending): initial cash investment (make it a negative number), each future annual cash flow (with the sales proceeds added to the last). Select a separate field and use the IRR function to complete the calculation.

3. Pro RE Calculator I developed Pro RE Calculator specifically to enable complex computations like these to be made quickly and easily. Just enter your data in the appropriate form and Calculate. The IRR result, solution, explanation, as well as an option to print appear immediately. (See screenshot below).

Rule of Thumb

The internal rate of return is a good measure of the rental property's potential profitability, but by itself, not enough to qualify the investment. The real estate investor must also consider many other factors such as economic and market area trends, financing, structural condition and location, and the income tax implications.

It should also be noted that one-size doesn't fit all. The real estate investor's particular objective determines whether or not the internal rate of return is appealing.

So You Know

Internal Rate of Return (IRR) is just one of 62 real estate calculations included in the following ProAPOD solution: