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. If you’re looking at the potential in your next investment, consider working with a financial advisor who can help protect your finances and identify the best investments for you.
Internal Rate of Return Defined
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.
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.
What Is a Good IRR for Real Estate?
Typically, the higher the IRR is the better the real estate investment could potentially become for you. A good IRR is going to depend on what type of real estate investment you’re making and what you expect to use the property for post-closing. For example, buying commercial real estate like an office building would be considered a strong investment with a 20% or more IRR. You can likely ask around in your specific area to find out what average and strong IRRs are for the type of investment you’re making.
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.
Limitations of IRR for Real Estate Investments
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.
The Bottom Line
The internal rate of return can be a good tool to help you analyze a potential real estate investment but it isn’t perfect. You’ll need to make a few assumptions and guesses to determine the cash flow on the property. However, it’s a tool that many real estate investors use every single day because it gives them a good indication of the potential investment.
Tips for Real Estate Investing
- Real estate can be one of the largest investments that you make. If you’re considering a new investment you may want to consult with a financial advisor to make sure you know that you’re approaching it correctly. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Another type of real estate investment that could give you the upside without worrying about the constant management of real estate is investing in a real estate investment trust (REIT). These are managed by firms who purchase several real estate projects and can pay out dividends on the performance of the portfolio.
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