Why IRR Matters: Evaluating Real Estate Investment Returns

By The ArborCrowd Team
Feb 24, 2017

Investors use several metrics to evaluate real estate deals, including internal rate of return (IRR), equity multiple, and cash on cash return. Of these, IRR is the most common and well-known metric utilized.

This article will explain the complex formula used to calculate the IRR. To understand how the IRR translates into profits for investors, visit ArborCrowd’s Real Estate Investment Returns Calculator.

IRR is closely tied to another investment metric, the Net Present Value (NPV), which is essentially the difference between an investment’s market value and its total cost1. To understand IRR, we must first understand NPV.

Net Present Value: Why it Is Used to Calculate IRR?

Any investment with a positive NPV will make money, just as any investment with a negative NPV will lose money. When looking for a real estate deal to invest in, you are only going to be presented with deals where the sponsor is projecting a positive NPV, as no one is going to bring a deal to market that is expected to lose money. But how would a sponsor determine if their proposed deal has a positive projected NPV?

For example, let’s say you are evaluating whether to invest in the value-add repositioning of an apartment community. To calculate NPV, the sponsor would first look at what comparable renovated properties are selling for — that’s the market value. Next, the sponsor would estimate the cost of buying, renovating, operating and selling the property — that’s the total cost. If total cost is less than the market value, they have found a positive estimated NPV.

How to Calculate IRR in Real Estate Investing?

Above we simplified IRR as the “annualized rate of earnings on an investment.” Now that you have a better understanding of NPV, we can present a more telling definition of IRR and look at how it’s calculated.

IRR = The interest rate that makes the NPV equal to zero

Put another way, an IRR is the interest rate that makes the market value and total cost equal. To determine IRR, we can take the NPV calculation below, define NPV as zero and solve for “r”.

\[N\kern -1ptPV = -C_0 + \sum_{i=1}^T {C_i \over (1+r)^i}\]

IRR Real Estate Example

Luckily, Excel does the calculation for us, enabling a quick determination of IRR based on cash distribution over a projected period. Below is an illustration of how IRR works for a $25,000 investment in a project with a projected hold period in the 5-year range.

Luckily, Excel does the calculation for us, enabling a quick determination of IRR based on cash distribution over a projected period. Below is an illustration of how IRR works for a $25,000 investment in a project with a projected hold period in the 5 year range.

Table showing IRR for an investment with a 5 year hold period and capital being returned each year.

The table on the left gives a quick overview of the cash flow over the five years, which for this particular scenario equates to an IRR of 13.94%. The right side shows what is going on behind the scenes for each year in terms of the Return on Investment and the Return of Investment. An investor would earn $15,000 in net profits over five years in Scenario A.

While it is helpful to understand how to calculate IRR, many investors still wonder what is a good IRR and what is a bad IRR. ArborCrowd’s article explains what investors should look for when evaluating different IRRs across different investment opportunities.

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