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What Is IRR and How Is It Used In Real Estate?

Christina

January 08, 2023

If you don’t have a firm grasp on what differentiates a good investment from a bad one, your real estate investments won’t succeed. Successful investment strategies hinge on the breadth of your financial knowledge. The more you know, the better equipped you are to make the right decisions.

What Is IRR and How Is It Used In Real Estate?

Familiarizing yourself with key financial metrics is the first step toward investing success. A strong grasp of key financial metrics like internal revenue return gives you the insights you need to properly assess an asset’s potential return. 

Explore the meaning of IRR and how it is used in real estate with Christina so you can make better decisions in real estate investing going forward.

What Is IRR?

Internal rate of return is a critical measurement used to assess the viability of a capital asset. It is used to analyze budgeting for an asset and thereby establish its potential profitability. IRR is an essential metric for investors seeking out investments that deliver a worthwhile return.

Internal rate of return gives investors a forecast of an asset’s risk by establishing its change in return from the present value to its expected value in the future. Crucially, IRR gives investors

better insight into the asset’s risk profile.

By clarifying the future value of an asset in today’s dollars, investors gain a comprehensive picture of an asset’s worth over the entire holding period (amount of time the investor holds onto the asset).

Any investment hinges on its enduring performance. Assessing an asset’s internal

rate of return reveals key information on whether a given investment is too significant a risk or a worthwhile decision.

How Does IRR Work In Real Estate?

IRR gives investors a strong advantage on the viability of asset classes like commercial real estate investment in particular. Real estate assets have many moving parts that determine their potential as investments. The capital budgeting established through the internal rate of returns is especially suited for real estate assets. 

What’s more, investors turn to real estate assets specifically for their many advantages as long-term investments. Since IRR presents investors with a clear picture of an asset’s projected value in the future, it is an integral metric for strategies that utilize real estate.

Establishing the IRR of a given asset serves real estate investors well. The more defined this metric is, the better understanding investors have about the risks latent in a given property or the potential strength of its return.

What Does IRR Tell You About Real Estate Investment Opportunities?

IRR utilizes key metrics that determine the value of real estate assets that investors need to know. Finding a property’s IRR clarifies two key metrics that drive value in real estate: appreciation and cash flow.

IRR Accounts for Appreciation

A primary reason investors utilize real estate as a long-term investment is its high rate of appreciation. Appreciation describes the growth of a capital asset’s value; the higher its appreciation, the higher its increase in value over time. Essentially, the sale price of a property will be much higher than the purchase price. 

Real estate appreciates well due to key characteristics that promote growth over a period of time. For one, it is inherently scarce. Land is a finite resource, and the slow pace of new development results in a chronically low supply of new property.

The steady, low baseline supply of real estate, in conjunction with reliably strong demand, means that property values are almost guaranteed to appreciate over time—as they have virtually without fail since the 1960s.

The projected value-add to real estate assets also stems from inflation. Healthy markets typically have a baseline annual inflation rate of 2 percent. In high inflationary periods, like the one the United States is experiencing currently, real estate values may rise as the dollar weakens.

IRR addresses the complexities appreciation and inflation have on the projected profitability of real estate by assessing its future value in today’s dollars. Calculating an asset’s IRR accounts for outside factors that drive growth, making the actual profit investors can expect from their investment as clear as possible.

IRR Predicts Future Cash Flow

IRR uses projected cash flow to determine its future potential. Cash flow is a measurement of the total money going into an asset. Understanding the cash flow balance is key to any investment; it gives a higher resolution assessment of an asset’s performance because it accounts for expenses and income earned.

Cash flow is crucial to real estate. Consistent expenses are to be expected with property ownership: property tax, mortgages, maintenance costs, and legal fees, to name a few. 

Income-earning real estate assets can do so in a few ways, most commonly it is through rental properties. Together, the balance between the money going into a property and the money coming out of it points to the financial viability of an asset.

In a certain respect, IRR measures the projected cash flow of a real estate asset over time. Calculating the predicted cash flow of an asset over a period of time tells a compelling story about its overall potential. Positive cash flow sustained over a long period is a clear indication that an asset is worthwhile.

How Do You Determine IRR on Real Estate?

There are a number of financial calculators available to investors that allow them to more easily assess key metrics like IRR. Furthermore, investment firms like Christina have the resources to assess these metrics for you.

Nevertheless, the deeper your familiarity with the IRR formula, the more complete your understanding of what it does and what it means for your investments. IRR is a fairly complex formula; to calculate IRR, one must first find a real estate asset’s net present value.

What Is Net Present Value?

Net present value is a high-resolution assessment of an asset’s value.

Here is how this valuation method is calculated:

  • Cash flow is divided by the required return, or discount rate, plus one; the number of time periods is an exponential factor on the discount rate plus one.
  • Subtract the initial investment from the number reached by the aforementioned step.

Net present value gives a comprehensive representation of an asset’s total. It establishes the potential of its cash flow in relation to the discount rate and acknowledges the initial investment amount put down on the property.

What Is IRR?

IRR is the discount rate that sets the net present value of an asset to zero. In essence, using the IRR calculation is a matter of finding the number that makes NPV equal zero.

This final number is not the dollar value of the asset, but rather it identifies the annual return rate that brings the total initial investment equal to zero. In other words, the rate return at which an asset recoups its investment.

A higher IRR can be a strong indicator that it is a better investment. A good IRR reveals a faster rate in which the asset nets the investor a balanced return—a faster balance to zero.

Here are some other formulas to be aware of:

  • Cash on Cash Return: calculates the annual rate of return
  • Cap Rate Formula: divides the net operating income by the value. A “good” market cap rate” is considered to be between five to ten percent

Why Is IRR So Informative?

IRR is so informative because it gives investors a clearer vision of a potential investment’s future. Knowing an asset’s IRR is knowing its projected growth; knowing the rate at which an asset will grow to recoup its initial investment outlay tells investors how quickly their returns will grow.

Other return metrics, while important, don’t give the detailed information investors get from identifying the IRR. Return on investment, or ROI, is mistakenly associated with IRR. While they are both concerned with an asset’s ability to generate a return, ROI provides investors with a far more limited perspective on the potential of their asset. What’s more, ROI is a calculation done in hindsight, the total return on the investment.

IRR provides investors with key foresight. The information obtained through IRR gives investors a reliable basis upon which they can speculate on the future performance of their assets.

What Are the Limitations of IRR?

While IRR is a highly useful metric for investors, it’s not perfect. Nothing is certain in the financial world; speculating on an asset’s future performance is never a guarantee. IRR is reliable, but it’s not watertight. The basis of IRR is the speculated cash flow of an asset over a certain period of time, which is always subject to change. 

A clear assessment of an asset’s cash flow is key to forming an accurate IRR. But accuracy of the formula cannot account for the future. IRR can only be relied upon if the present assessment of an asset’s cash flow holds true over time. It may be that an asset’s cash flow is impacted by external factors: a weakening market, prolonged vacancies in a rental property, and cascading repairs.

The realization of a promising IRR depends on a number of factors, like an asset’s quality and ongoing maintenance of it. Investing with a firm equips you with the resources to ensure that your real estate investments’ internal rate of return is seen through.

Investment Decisions: Excel With the Best

Christina has secured its investors a return on premium real estate assets for over 40 years. The team at Christina brings investment opportunities to people who might not otherwise dip their toes in the lucrative real estate market of the luxury Westside region of Los Angeles. 

Specializing in multifamily commercial real estate, investment properties have never been more attainable. 

Get started with us today and increase the high IRR assets in your portfolio for tomorrow.

Sources:

Median Sales Price of Houses Sold for the United States | FRED

October Inflation Report Price Pressures Show Signs of Cooling | New York Times

Is the U.S. in a Recession? What Key Economic Indicators Say | FRED

Formula for Calculating Internal Rate of Return (IRR) in Excel | Investopedia

Capitalization Rate: Cap Rate Defined With Formula and Examples | Investopedia

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