The internal rate of return (or IRR) is only one of many approaches used to make real estate investment decisions, still it is one of the more popular rates of return real estate investors use to measure rental property profitability.
Because it calculates for time value of money, it thereby allows real estate investors to consider both the timing and the scale of those future cash flows expected to be generated by a rental property.
As a result, the investor can determine the rate of return to expect on his or her capital investment based upon anticipated future income streams with IRR.
Internal rate of return on an investment (expressed as an annual percentage) is the rate of return that makes the net present value of all future cash flows (both positive and negative) from a particular investment equal to zero.
To be more specific, internal rate of return is the rate at which all future cash flows are discounted so that the present value all future positive cash flows from the investment are exactly equal to the present value of the negative cash flows (costs) of the investment.
In other words, IRR establishes the rate that all future incomes must be discounted so that the present value of all those future incomes exactly equal the amount of money initially invested.
Investment Value is the capital investment
Cash Flows (Annual) is the annual income streams
Cash Flow (Reversion) is the amount received when the property is sold
t runs from 1 to n and is the number of time periods (years) in the holding period
r is the internal rate of return
Making the Computation
Trying to compute IRR manually requires a great deal of time that makes it impractical. So you would probably want to use a a third-party device or program to make the computation for you.
- A hand-held calculator like an HP-10B or HP-12C
- A spreadsheet program like Microsoft Excel
- ProAPOD iCalculator
Okay, let’s say you plan to invest $435,000 for a rental income property that you are planning to hold for six years. You are projecting that it will generate annual cash flows of 43,950, 45,504, 47,108, 23,762, 50,468, and 52,227 along with 520,000 at the time of sale and you want to know what to expect as an internal rate of return.
1. HP Financial Calculator
For our purposes, I will refer you to the HP Owner’s Manual. HP is very proficient. But to make the calculation for our example you will have to make about ten separate key entries (plus a separate calculation to total the sixth cash flow and proceeds at disposition). So it is somewhat time consuming.
2. MS Excel
You would want to make the following entries in cells like these:
A7: 572227 (sum of sixth cash flow plus proceeds at sale)
10 = a guess at the rate (10 is Excel’s default value)
3. Pro RE Calcualtor
Pro RE Calcualtor consists of a single form that enables you to enter the cash flow values directly. No need to make a separate total for the final cash flow and sales proceeds. The image below illustrates the IRR calculation (click to enlarge).
Based upon the projected cash investment and cash flows from the rental property, the internal rate of return is 12.40%. If this rate is equal to or greater than the investor’s required rate of the return the investment may be accepted; otherwise it may be rejected.
It should be pointed out that IRR may not be possible to solve when negative cash flows are projected in the future. In this case, you might consider a technique such as modified internal rate of return (MIRR) or financial management rate of return (FMRR).
So You Know
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