What the Internal Rate of Return Tells You

Real estate investors were glad to see this metric come along, since there had been scant few ways to evaluate the profitability of an existing or potential project.

As popular as it is, it still doesn’t come close to the easy and straightforward way anyone can check on the status of their stocks.

Still, IRR is an imminently useful and important gauge, particularly among those in commercial real estate. It helps investors make their way through the often-complicated real estate market as well as to make better decisions. But do you know what the internal rate of return tells you? Let’s look at that – and more.

Internal Rate of Return

Real estate investors essentially use IRR to see what kind of average rate of return they can expect on a project, on average, and at length. 

Expressed as a percentage, IRR can apply to the performance of a current investment as well as a prospective one.

How IRR is Used

IRR can not only tell you how an existing property’s performing, but it can predict the rates of return on investments you’re considering. Moreover, internal rate of return helps investors gauge the likely profitability of a certain real estate project -- as compared to other projects or even another investment such as the stock market.

Time and Profit

These terms form the basis of IRR. “Profit” is what you might imagine: any earnings above the initial investment outlay. It can be realized as mortgage or rent payments, or the sale of a property. The caveat here is that to accurately calculate their profits, investors must subtract costs incurred for each investment, costs such as property taxes or for ongoing maintenance.   

“Time” is a bit more nuanced when it comes to IRR. After all, factors such as housing market trends and inflation will affect a property’s value at any point in time. There’s no metric that can account for that. Compounding the issue is that $100 today is not only not worth what it was a decade ago, it won’t be worth the same 10 years from now. Because the value of money invariably changes, so does profit.

In that way, it can be said that internal rate of return is used to get a better handle on a property’s realized or prospective profitability as it relates to time in a myriad of ways.

The Formula

This is not easy math, we’re talking here, and involves terms like net present value and current cash flow. The great news is that you or your business manager will be able to handle the calculation via spreadsheets or by using a specialized calculator.

Complexity notwithstanding, what’s important for you to know is that IRR is a practical way to fix a project’s prospective profitability. 

Downsides of IRR

We mentioned up top that IRR is not a perfect tool, as commonly used as it is. In fact, IRR results are necessarily just estimates of what returns “might” be, based on several assumptions rather than facts. Also, IRR doesn’t consider a project’s risk, even a project with an overwhelmingly favorable result. What if average rental rates unexpectedly plummet, or a property is found to have significant and costly undisclosed damage? 

The issue is that, before relying exclusively on IRR, you must understand that there will always exist variables that are outside your control that must be considered.

Now you know what the internal rate of return tells you – and what it doesn’t. Overall, IRR is a very helpful metric that real estate investors can use to help them make smarter decisions. If you wish to learn more, we suggest that you check out the alternative platform Yieldstreet, which has resources you can use.