The internal rate of return (or IRR) is generally one of the most popular rates of return used by real estate investors trying to measure the financial performance of a rental property because it calculates the time value of money. Therefore, because it provides an association between the present value and the future value of the income stream, it allows the investor to take into account both the timing and scale of the cash flows generated by the income-producing investment property.
Okay, that’s a mouthful, but bear with me. This article will really try to explain what internal rate of return is in a way that you and I are more apt to understand.
Here’s the idea. The IRR has to do with the rate of return that the investor can expect on the capital that he invested to purchase a rental property based on anticipated future income streams. That is, future income divided by initial investment equals the rate of return.
But in this case, instead of simply dividing the amount of those future income streams by the amount of the investment, the IRR applies a “discount rate” to calculate the “present value” of those future incomes before dividing them by the investment amount. investment.
A simple illustration will help explain why this is important.
Let’s say you were given the option to collect $10,000 today or wait to collect it a year from now. Which option would you take? Of course, you would take the $10,000 today because you no doubt understand that inflation erodes purchasing power over time and in a year, $10,000 won’t buy you as many goods as you can with the same amount today.
The internal rate of return deals with the same assumption and, as a result, considers the “present value” of projected income streams, not just projected (unadjusted) income streams. Let’s consider another example.
Suppose you invest $100,000 to purchase a rental property that produces a cash flow of $5,000 for one year; In addition, the property is expected to sell for a profit of $20,000 at the end of the same year, in other words, future income. projection for a total of $25,000. However, instead of simply dividing the $25,000 by $100,000, which in this case is 25.0%, the IRR first discounts that future income and then does the math. For example, at a discount rate of 10%, the present value of future income becomes $22,727 and, when divided by the investment, gives a rate of return of 22.73%.
You see the difference? While the first method (not discounting future income streams) calculates a return of twenty-five percent, the internal rate of return method (discounting future income) calculates a significantly lower return and certainly closer to the reality.
You can preview various reports created by the real estate investment software referenced in the resource box below that calculate this performance.