Trying to calculate internal rate of return (or IRR) manually is not very practical for real estate investors, or anyone else for that matter, 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 formula for the return, and instead would resort to a financial calculator, Excel spreadsheet, or third-party software program to compute it for them.
So rather than to display the actual formula for IRR (which can be found in other places on the web) let’s instead focus on the concept to show you how to make the calculation without knowing the formula.
Concept
In essence, the internal rate of return is the unique rate that discounts the sum of future cash flows until it equals the initial investment.
- “Initial investment” is the cash investment made by the investor to purchase the income property.
- “Future cash flows” is the cash derived each year the income property is held plus the reversion (the proceeds received upon sale of the property).
In other words, IRR is the “discount rate” that will discount all future cash flows (which are future value) to equal the present value of initial cash investment (which is present value).
Application
Let’s say that you’re an investor looking at a rental income property and would like to know what your IRR would be if you held the property for six years. You have to initially invest $435,000 cash to make the purchase, are projecting the property to generate annual cash flows of $43,950, $45,504, $47,108, $23,762, $50,468, and anticipate (based upon your projections) to collect $520,000 upon a sale of the property (reversion) in the sixth year.
- Initial investment: 435,000
- CF1: 43,950
- CF2: 45,504
- CF3: 47,108
- CF4: 23,762
- CF5: 50,468
- CF6: 52,227
- Reversion: 520,000
Formulation
First, make your initial cash investment a negative amount to reflect it as a cash outlay. Secondly, combine the sixth years’ cash flow with the reversion (sale proceeds) to show the total amount of anticipated cash flow for year six.
- CF0: -435,000 (initial cash outlay)
- CF1: 43,950
- CF2: 45,504
- CF3: 47,108
- CF4: 23,762
- CF5: 50,468
- CF6: 572,227 (total cash flow in sixth year)
Finally, apply the rate that will “discount” all future cash flows until that total amount exactly equals the total amount of the present value (the initial cash outlay) and that rate will become the internal rate of return.
Fair enough. But, like I said, it’s not that simple. So allow me to share several resources you can use to make the IRR computation for you.
1. Financial Calculator
The hand-held financial calculators like HP10 and HP12 both make the IRR calculation but they are somewhat tedious because they require a series of key-strokes.
2. Excel Spreadsheet
With Excel you would enter the amounts as illustrated in the schema above and then use Excel’s IRR function. The illustration below shows the result.
3. Rental Property Software
To avoid making the IRR calculation manually, you can also opt to invest in a third-party software solution that creates a rental property cash flow analysis. Just be sure that the software includes computations for time value of money. My own ProAPOD Real Estate Investment Software does include time value calculations and requires you to only populate the forms with the property’s financial data.
4. iCalculator
Excuse one more shameless plug, but I would be remiss not to inform you about the online real estate calculator I developed called iCalculator. It’s by far the quickest and most affordable way to make the IRR computation. Plus, it requires you to populate just one form. The illustration below gives you the idea.
So You Know
iCalculator makes dozens of real estate calculations with the formulas. You can try it risk-free and save 64% (you pay just $24.95). Click here to learn more and get the discount.
