Internal rate of return, commonly referred to as IRR, is widely used by real estate investors to assess the profitability of a current or future project. It’s an important metric, if only because, unlike with stocks and bonds, there’s no straightforward way in real estate to know how an investment is performing or likely will perform.
Still, the tool does have its imperfections.
Here are some pros and cons of using IRR.
What is the Internal Rate of Return?
Let’s start there. Internal rate of return is a way of calculating just that: an investment’s rate of return. Central to its definition is the term “internal,’ which refers to the fact that the IRR formula excludes several external factors. Those factors can include such things as inflation, the risk-free rate, financial risk, or the cost of capital.
How is IRR Primarily Used?
An IRR can gauge the performance of current investment in addition to what might be expected from a potential investment. This is one of the tool’s benefits, by the way: its functional duality.
Expressed as a percentage, IRR tells an investor what they will likely earn from an investment, on average, over time.
Profit and Time
These two terms are key to how IRR functions in real estate. “Profit” is easiest to understand. This can include anything from a property’s cash sale, to rent or mortgage payments. In general, profits are any earnings that exceed the amount of the initial investment, minus any investment costs such as ongoing maintenance and property taxes.
The term “time,” however, is markedly more complicated when it comes to determining an internal rate of return. Why? Because inflation and other market forces, such as those having to do with housing, can muddy IRR results. After all, $20 today is worth less than it was 20 years ago, and it’s likely to be worth even less 20 years from now. Therefore, at length, the value of money, and thus, profit, will invariably change.
What are the Pros and Cons of IRR?
The following are some advantages and disadvantages of IRR, starting with the benefits:
- IRR considers the time value of money. Because all future cash flows are folded into the calculation, every cash flow is weighted equally when considering money’s value from a time perspective.
- The calculation is easy, even if the formula isn’t. Fortunately, an IRR calculator makes it all simple.
- It helps you to compare projects in terms of likely profitability, which helps you to set priorities.
- It can be used with other metrics. In fact, it should be. That way, you can compare the result you get from IRR to other business factors.
As for the IRR’s downsides:
- IRR can deliver an incomplete view of the future. Why? Because the cost of capital need not be part of the equation.
- It doesn’t consider a project’s size or scope. IRR only compares the cash flows to how much is being spent to produce those cash flows.
- It doesn’t consider prospective costs, such as fuel and maintenance, that may affect future projects.
- It doesn’t consider reinvestment rates. IRR assumes the value of future cash flows can be reinvested at the same rate as the IRR. That’s not always a practical assumption.
As you can expect from a metric of this nature, there are indeed pros and cons to using IRR. However, it is still a useful tool. If you wish to learn more about investing in commercial real estate, the alternative investment platform Yieldstreet has some resources that will be of assistance.