Most real estate investors use the internal rate of return (IRR) to gauge a project’s viability. The higher the IRR, the faster the investors are likely to receive a return on their investment.
When it comes to real estate investing, the time value of money is critical because the dollar’s worth depreciates over time owing to factors such as yearly inflation and supply and demand fluctuations. As a result, the internal return rate gets significantly impacted.
But what is a good IRR? Many real estate investors confuse cash returns or even the Average Annual Return (AAR) of Real Estate Investments. The AAR is the average annual return you may expect throughout a project’s lifespan. However, IRR is the percentage that does not necessarily translate into an actual sum as the ARR does.
Multi-family property investments should not be based on IRR but rather on other metrics, such as cash flow and capital appreciation.
How to calculate return in real estate with the help of IRR?
Real estate does not provide the same daily insights into price and performance as publicly traded stocks. Because of this, it may be more challenging to assess the rate of return in the past or the predicted future.
However, since the return on investment in real estate is calculated using an IRR, it is the most frequently acknowledged method for determining its profitability. If you need to know what is a good IRR, then a project with a positive internal return rate means that the investor has achieved a good return on the investment. Conversely, a negative IRR means a project will be a loss.
By properly weighing the cash flows, investors can directly compare their options. The internal return rate for most real estate investments is merely an estimate based on assumptions.
Therefore, it is vital to keep this aspect in mind. The final internal rate of return can be calculated once the investment is sold. The formula involves finding a discount rate or interest rate that sets all cash flows for the project to zero NPV.
Some examples of the calculation:
Find an IRR for a 5-year investment with no annual distribution
Suppose your initial investment is $1,000. You have no cash flow in 5 years. And the first $1,000 is collected at the end of the fifth year. In this case, IRR will be zero. This is because no cash flow was received, and the initial investment was paid off in 5 years. Therefore, it did not generate any additional profit.
Find the IRR of a 5-year investment with an annual distribution
If your initial investment is $1,000. Your project receives a $100 annual distribution. And the first $1,000 was recovered at the end of the fifth year. In this case, the real estate’s internal return rate is 10%. It means that the investment earned 10% annually.
Several factors influence a project’s return rate. A high IRR does not imply that the investment will pay off in the long run. The internal rate of return calculation, for example, does not consider the project’s size, risk profile, revenue generation period, or actual profit realized.
So, it is difficult to precisely forecast real estate investments’ rent and occupancy risk. Nevertheless, it is a helpful tool for calculating real estate property valuation.