What is the Internal Rate of Return (IRR) in Real Estate?

The internal rate of return (IRR) in real estate, is one of the most scrutinized metrics. Private equity (PE) firms entice investors with guarantees of specific IRR values in order to obtain capital. 

Additionally, promoting interest, which is frequently the lifeblood of a private equity real estate company—will depend on the IRR value of a deal or fund as well as the promises made to investors when the transaction was first secured or capital was first obtained.

For private equity real estate firms, setting a target IRR value is one of the most important aspects of commercial real estate valuation. The same applies even if you don't work for a giant PE firm and just are trying to figure out what kind of IRR to shoot for with your own deals.

IRR Real Estate Definition

The internal rate of return is the discount rate at which the net present value of a sequence of cash flows such as the value of the initial investment, stated negatively, and the value of the returns expressed positively—equals zero.

It is the pace of growth of an investment in real estate, to put it another way. In this regard, it might be compared to a compounded annual rate of return that is time-sensitive.

It is a calculation used to gauge the profitability of possible investments. As it measures the percentage return generated on each dollar invested for each period it is invested, it is frequently used in commercial real estate as an investment performance measure. IRR is an important calculation for organizations since it aids in planning for growth and expansion.

IRR, which is frequently used to assess investments or projects, sets the net present value (NPV) for a particular investment to zero. Based on the desired rate of return, a firm or business might determine by looking at the IRR whether or not to accept the investment offer.

If the calculated IRR exceeds the required rate of return for the firm or is comparably higher, they will probably decide to accept the project. On the other hand, the investment might be turned down if it falls short or if another project offers larger returns.

What Does IRR Tell You?

A higher IRR often denotes a higher return on investment. An IRR of 20%, for instance, would be seen favorably in the field of commercial real estate, but it's crucial to keep in mind that it's always correlated with the cost of capital.

An excellent IRR would be one that exceeds the initial sum that a business has put into a project. A negative IRR would also be undesirable because it would indicate that the project's cash flow was less than what was first invested.

Since NPV and IRR are closely related mathematically, understanding NPV is equally crucial for understanding IRR. The difference between an investment's market value and its total cost is known as net present value. You will profit from investments with a positive NPV while losing money from those with a negative NPV.

In order to ascertain a property's market worth, for instance, you would need to first determine what other comparable properties are selling for. Next, you would need to determine how much it would cost to buy, renovate, and maintain the property which is the total cost. You'd have a positive NPV if the whole cost was less than the market value.

In what way does this relate to IRR? If the NPV is known, then the IRR can be calculated by finding the interest rate to make the market value and total cost equal. 

How to Calculate IRR in Real Estate

NPV can be manually calculated by setting NPV equal to zero and solving for IRR using this formula:

0=NPV=n=0NCFn(1+IRR)n

where:

NPV = Net present value

N = Total number of time periods, e.g., if a project will take you five years to complete, N = 5

n = Time period, e.g., for the first year of a project, n = 1

CF0 = Initial investment 

CF1, CF2, CF3, etc. = Cash flows, i.e. income or investments

IRR = Internal rate of return

With a pencil and paper, calculating the internal rate of return can be challenging and time-consuming. Manually, you would have to use trial and error to figure out the IRR because the NPV is calculated using estimated interest rates.

Fortunately, there is a useful feature available on Microsoft Excel that enables you to input your time frames and cash flows to more effectively calculate the rates of return on an annual basis.

How to Calculate IRR in Excel

Based on how much information you have about the investment up front, there are three different IRR functions.

  1. IRR function calculates the rate of return for a series of cash flows with equal-sized payment periods.
  2. The extended internal rate of return (XIRR function) calculates the rate of return for a set of cash flows with various payment period lengths, which can produce a more precise rate than the default IRR function. 
  3. The modified internal rate of return (MIRR function) calculates the return on cash flows taking into account borrowing costs and compound interest generated by reinvesting cash flows.

You can find the functions by clicking on the Formulas Insert (fx) icon.

Among the calculations, IRR is the simplest, whereas XIRR and MIRR provide more precise results. It is best to calculate all three functions in order to get the most accurate estimate of an investment's potential profitability.

Calculating IRR in Excel is easy with these functions. The Excel formula even calculates your discount rate for you, saving you time and effort. By using the IRR function, you can combine your cash flows, including both the initial outlay and the subsequent inflows.

Why a Larger IRR isn’t Always the Goal?

In general, it is assumed that bigger is better—for example, a 15% IRR is considered more attractive than a 10% one. However, if used alone, an IRR analysis can be misleading. When comparing real estate investment opportunities, it is also important to consider how an investor achieves that IRR.

At face value, a bigger IRR might appear good, especially with real estate funds and their high returns and flexible options. But investors need to look deeper to find out how it was calculated, as well as consider the need for operational distributions.

In order to analyze the merits of a particular real estate investment offering, investors often combine IRR with other metrics. If you want to learn more about the internal rate of return in real estate, it is wise to discuss it with a financial expert.

Our team can help, email us at general@saintinvestment.com or contact us at 949-881-7128 at Saint Investment Group today!

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