One of the more commonly used measures by real estate investors to gauge a rental property’s financial performance is internal rate of return (or IRR); primarily because it considers time value of money.
An advantage to investors because with time value of money consideration both the amount of the cash flows generated by an investment property as well as the timing of those cash flows can be gauged. Bottom line?
Internal rate of return provides a good way for investors to determine whether the property will be profitable in the future as compared to other real estate investments.
How IRR Works
Basically, IRR considers the “present value” of all future income streams a property might produce and reveals the rate of return an investor might expect on the amount of cash outlay required to acquire the property.
The concept is logical.
The money invested to make a purchase today has value in today’s dollars. Whereas money collected in the future typically has less purchasing power than it would today for a variety of causes such as inflation rate.
So it makes sense that a real estate investor would want to equate the purchasing power of tomorrow’s revenue dollars with the purchasing power of today’s investment dollars to get a truer sense of rate of return.
Think of internal rate of return as a reverse application of a savings account.
You invest into a savings account knowing the amount of investment and yield (IRR), and then compute a future amount. Whereas with rental income property, you know the amount of investment and anticipated future amounts, and then compute the yield (IRR).
In the context of savings and loans, the IRR is called the “effective interest rate” and expresses the “future value” of your investment when “compounded” at regular periods over time at that rate.
In the context of real estate investing, the IRR expresses the “present value” of your future earnings at regular periods over time “discounted” at that rate.
In other words. Rather than applying an “effective interest rate” to today’s dollars to calculate tomorrow’s savings account dollars, you look to IRR to express the “interest rate” that today’s dollars will earn you based upon income streams planned to occur at regular periods in the future from the investment property you plan to purchase.
Rule of Thumb
Generally, real estate investors will go ahead with the real estate investment when the internal rate of return is less the cost of capital required to make the investment.
Whereas, he or she typically might pass if the IRR is more than the cost of the investment and a better rate of return can be had on some other investment.