Advanced real estate concept 101: Calculating IRR
If you've looked at investments, you might have seen an IRR calculation given. It's a percentage such as 12% or 9%. The IRR is commonly thought of as your annualized compounded return based on your initial investment.
The IRR helps you compare investment returns. IRR differs from Cash on Cash Returns and Cap Rate in that the IRR considers all the cashflows over the lifetime of your investment and also accounts for the time / value of the money principal.
The time / value of the money principal is the idea that a dollar now is worth more than a dollar in the future. Why? For one reason: inflation. Inflation drives prices up so that a dollar in the future will buy you less than what it will buy you today. Also, a dollar now can be reinvested for more returns whereas a dollar in the future cannot be invested (until you receive it).
So the IRR takes that into consideration. If your cashflows look like this:
Year 1: $10,000 Year 2: $10,000 Year 3: $10,000
The IRR will give more value or weight to Year 1's cash flows then it will for Year 3's cash flow. The further out into the future you receive your cash flow (Year 7, Year 10, Year 30, etc.), the less value will be assigned. The IRR calculation does this by discounting the cash flow back to present day values.
So a Year 1 cash flow of $10,000 is worth $10,000. But a Year 3 cash flow of $10,000, when discounted to present day values, might only be worth $9,000 in today's dollars. Why? Because over time, the dollar loses its value.
The amount of that discount will be automatically calculated by the IRR formula. The IRR calculation does this by giving us the compounded interest rate of your overall return. By using the compounded interest rate, the IRR makes sure that the further in the future you receive your cash flow, the lower it's value in today's dollars.
(In technical terms, the IRR finds the discount rate that would bring all future cash flows to the net present value of zero.)
When doing an IRR calculation, you start first with a negative number. That negative number represents your 'initial investment.' The number is negative because it's money that's coming out of your pocket.
After that, you list (your assumptions) all the cashflows you think you'll receive over the lifetime of an investment. Usually this means your annual profits from rent (after expenses are subtracted). These numbers are positive because this money going into your pocket.
In the year you plan to sell your property (for example, let's say in year 10), in addition to rent, you'll also include your cash from the sale.
Be Aware of How This Change in IRR Calculations can Affect Your Return
I've included a screenshot of two different IRR calculations.
In one of the calculations, the initial investment of -$100,000 is listed as Year 0, and then the cash flows are listed. In the column next to it, the initial investment includes Year 1's cash flow, so instead of -$100,000, it's listed as -$90,000:
-$100,000 + $10,000 = -$90,000
Look how that changes the IRR.
Keep that in mind when you're presented with IRR numbers on a real estate proforma (proforma = an estimate of how much a property will earn, usually given to you by a real estate agent). If the proforma has combined Year 1's initial investment and Year Income, the returns will always look higher.
The correct way to calculate is to separate the initial investment as Year 0 (or calculate it month by month).
And so that concludes this mini lesson on IRR. If you're having a hard time grasping it, don't worry. It's probably due to my poor explanation.
It took me a while to get a better feel for the concept, and even this past weekend, I spent a long time going over my spreadsheet formulas to make sure I understood what was going on. It helped that I had a few other people to chat about it with.
What do you think? Do you have any questions? Leave a comment below.
(Banner photo by Jorge Franganillo, Flickr)