When it comes to turning a profit on investments, the trick is knowing how to balance the risks against the potential rewards. Calculating a real estate property’s capitalization rate can give you a ballpark figure of what kind of returns you stand to earn for a fixed point in time. The internal rate of return (IRR) is a more exact measurement of a property’s long-term yield and it’s a good concept for real estate investors to be familiar with.
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A property’s internal rate of return is an estimate of the value it generates during the time frame in which you own it. Effectively, the IRR is the percentage of interest you earn on each dollar you have invested in a property over the entire holding period.
For example, let’s say you purchase a commercial office building to lease out and you plan to hang on to the property for 10 years. You’d earn interest on the rental income you receive during the first year for the remaining nine years. Income received in the second year would earn interest for the next eight years, with each new year generating more interest. All the interest earned over the full 10-year period would represent the IRR.
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IRR vs. Net Present Value
The IRR of a particular property is typically associated with another real estate investment term – net present value (NPV). The NPV is the value of a property’s expected cash flows minus the initial investment amount.
For investors, a positive NPV is ideal because it means the property will yield the desired rate of return. When the net present value is negative, that means the property is likely to underperform. To calculate the IRR, you would set the NPV to zero.
Why Calculating IRR Is Useful
Unlike the cap rate, the IRR is a well-rounded way to estimate a real estate investment’s profitability. Because the IRR looks beyond the property’s net operating income and its purchase price, (which are used to calculate the cap rate) you get a clearer picture of the kind of returns the investment will generate from start to finish. This can be extremely helpful if you’re planning to invest in real estate for a long period of time.
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Beware the Limitations
While the internal rate of return can tell you a lot about a property, there are drawbacks to relying on it to compare real estate investments. Calculating the IRR involves a certain amount of guesswork because you’re effectively making assumptions about the amount of cash flow the property will generate and how the overall market is going to perform.
If any surprise costs pop up or you can’t sustain the kind of rental income you had in mind at the outset of the investment, your original IRR calculation may be rendered useless. When you’re using IRR to evaluate multiple investment opportunities, it’s important to keep it in context. Sticking with properties that are similar in terms of the amount of risk involved and the holding period will make it easier to draw comparisons so you don’t make mistakes when trying to choose the right investment.
If this all sounds like a lot to suss out on your own, consider working with a financial advisor. If you don’t have one already, a matching tool like SmartAsset’s SmartAdvisor can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and your goals. Then the program will narrow down your options to three fiduciaries who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
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