What is IRR and How is it Calculated?
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The internal rate of return is a metric used to measure the level of cash outflows versus the cash inflows of an investment over a particular period of time discounted back to the current period.
For example, an investor may be interested in buying a property that costs $150,000 and then renting it out for $1,000 a week during the summer months. As a result, it will cost him $150k up front and then he will pull in $15,000 a year for the next 15 years. After that period, he plans to sell the property for $165,000 because he believes that the market will have appreciated.
During the first year, his cash outflow is $150k. During the second year, his cash inflow is $15k, which is an annual rate of return of 10%. However, that 10% has to be discounted back to the current period using the discount rate (usually the rate of return on a 1-year treasury note, which is currently .87%).
As a result, that $15,000 which the investor will gain in one year from his property is actually worth $14,870.63 today when you account for the time value of money.
Now, in order to get the IRR for an entire project, our man would need to add up all of his cash flows and discount them back to period 0 (the present day) in order to find his number. Given the example above, this would give his particular purchase a rate of return of 10.307% over the next 15 years.
How to Calculate Internal Rate of Return using Excel
In order to calculate this figure on your own, you can use Excel to make the process fairly expedient. Steps are as follows:
1) First, enter in your projected cash outflows and inflows over the given time period that you expect to hold your investment in a single row. Typically, all cash outflow will happen at time “0”, then cash inflows will happen at time(s) 1-x.
2) After that, select an empty cell and enter “=IRR(“. At this point, it will ask you to enter “values”. Simply select all of your cash outflows and inflows, starting with the outflow that occurs in period 0 if you were to buy the property.
3) Hit enter, and Excel will provide you with the figure that you are looking for.
What Constitutes a Great Property Purchase?
Of course, simply finding a positive rate does not necessarily mean that a certain piece of real estate will produce a good return, nor is an internal rate of 12% necessarily better than one of 8%. This is for a number of reasons, the simplest of which being that your figures are going to be forecasted.
In our prior example, the real estate investor believed that he would make $15,000 each year on his property, but what if he actually only makes $11,000? That would completely change the true rate of return, which may invalidate the investment as being a good one.
This is why it is incredibly important that an investor create a worst-case, best-case, and most likely scenario for each property purchase and then temper his expectations according to the weighted probability of each return scenario.
Taking the WACC into Account
Secondly, the rate of return that an investor expects must outpace the weighted average cost of capital (WACC). WACC is the cost that an investor will pay to finance his purchases. In some rare cases, an investor may be able to pay cash outright for his purchases, but this is often not possible.
In the case of housing and commercial properties, a buyer will often have to finance his expenditures with mortgage loans or, in our current day and age, some type of crowd funding (i.e. Lending Club or Lending Tree). **While, traditionally speaking, mortgage loans have been the only way to purchase property, crowd funding can often provide loans at much cheaper rates today.**
Referring to the prior example, let’s say that the investor is able to pay $75k of the $150k purchase upfront in cash. Meanwhile, the mortgage rate the bank gave him was 5%. Now, since he paid for half of the purchase with cash, this means that only half of the purchase is financed. As a result, his WACC would be .5*.05=.025 or 2.5%.
In other words, his internal return rate each year would have to be greater than 2.5% in order for the investment to even have a chance at success.
Putting it All Together with Net Present Value
Finally, we must realize that the goal of our investor is to obtain the best return for his money…Not just a good return. With the internal rate, this can be a little bit tricky. This is because the internal rate could be higher for one property than another, yet the latter property would produce a greater return.
This is why we must combine our internal return figures with both WACC (to first find out if the property is even a feasible investment) and Net Present Value or NPV (to discover which investment has the most potential value at the present time).
I won’t bore you with the doldrums of how to calculate NPV since that is not the purpose of this article, but I would direct you to this article by Investopedia if you would like to learn how.
Net Present Value is the sum of the differences between projected future cash flows and the current cash outflow discounted back to the current period. I know that is a mouthful, but it basically shows us the dollar value of what an investment is worth today.
In some cases, a project with a lower internal return rate may have a higher NPV, which means that the project with a lower internal return rate could have a higher real return (in dollars) than a project with a higher internal return rate.
Knowledge is Heavy, But the Returns are Worth It
Take no doubt, the successful property investor will have to be an excellent data processor and analyst at heart. Property investment has the potential to deliver massive returns when one gets into the ebb and flow of it, but it requires a high level of upfront investment.
In many ways, I believe that the time investment to learn the required knowledge to be successful in this arena is far more costly than the simple money investment that must be input.
Furthermore, this is not an industry where one attempts to “get rich quick”, as many property investment schools and sales groups will often tout. It takes time, it takes money, and it is very, very difficult to become successful like you would probably like to be.
For more information about commercial crowd funding and how you can get into commercial real estate without millions in down payment and above average returns click the link below.