Internal rate of return (IRR) is one of the rate of return
measurements more widely used during a real estate analysis
for good reason: The aspect of time value of money
associated with internal rate of return considers that the
timing of receipts from the investment property can be as
important as the amount received.

Unlike some other popular returns used by investors to
analyze the performance and profitability of rental income
properties that don't account for the time value of money
such as capitalization rate and cash on cash, IRR does.

As a result, because it calculates for time value of money
and provides a linkage between present value (PV) and
future (FV) of any benefit stream, internal rate of return
is generally more popular amongst real estate investors
than other rates of return.

The idea is straightforward.

Because a dollar in the hand today is preferable to one a
year or five years from now, real estate investors want to
take into account both the timing and the scale of cash
flows generated by the income-producing property to
determine what that rental income stream is worth today.
Internal rate of return reveals the rate at which future
cash flows must be discounted to equal the amount of
investment exactly.

How IRR Works

Internal rate of return reveals in mathematical terms what
a real estate investor's initial cash investment will yield
based on an expected stream of future cash flows discounted
to equal today's dollars, not tomorrow's dollars.

Consider this.

When you make a real estate investment, you are investing
cash in order to receive a series of future annual cash
flows resulting from rental income plus a tidy profit when
you sell the property.

The challenge for real estate investors, then, is to
discover what rate of return the investor's initial equity
will make based upon those periodic future cash flows at
the same time it considers the number of time periods
(years) under consideration in the holding period.

The internal rate of return model meets that challenge by
creating a single discount rate whereby all future cash
flows can be discounted until they equal the investor's
initial investment.

How to Calculate

Calculating IRR manually is not practical because the
calculation involves tedious mathematical solutions that
take a lot time. Even skilled real estate analysts
typically use a financial calculator or real estate
investment software program to compute it.

So we'll ignore the formula (you can find it online if you
really care to know it) and instead consider what it
signifies.

Let's assume that you have $300,000 to invest in an
income-producing property and plan to hold it for seven
years. During those years, you plan on receiving five
annual cash flows and then an additional amount from the
sale of the property (also known as reversion). When you
find the unique rate of return that discounts the sum of
all those future cash flows until it equals your initial
investment, you will have the internal rate of return.

In other words, it shows you what your cash investment will
yield for those cash flow projections based upon today's
value of the dollar, or as if those cash flows were
collected today rather then in the future.

You should not, of course, rely on one single element of a
real estate analysis to the exclusion of other factors and
measurements to make your investment decision. But internal
rate of return can help guide your purchasing decision so
plan to use it.

One final thought. If you are serious about real estate
investing, then it is highly recommended that you invest in
a real estate investment software solution. In this case,
you not only will get a wide range of essential returns
that includes IRR, but also benefit from all real estate
analysis features that quality investment software provides.

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James Kobzeff is the developer of ProAPOD - leading rental
property real estate software since 2000. Create cash flow,
rates of return, and other real estate analysis
presentations in minutes. IRR and other returns made
automatically! Learn more at => http://www.proapod.com

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