Why You Should Know Your Property’s Internal Rate of Return (IRR)

Internal rate of return (IRR) and return on investment (ROI) are two critical performance metrics for real estate investors.

But do you understand the difference?

They both offer ways of quantifying how well your investment is doing, but IRR is the one that is often under-appreciated and misunderstood. In this article, we’ll show you why overemphasizing ROI and ignoring IRR is a serious mistake if you’re a sophisticated real estate investor.

We’ll tell you what IRR is and how it differs from ROI, how to calculate it, and what it does (and doesn’t) tell you about your rental property.

Internal Rate of Return: IRR: bored baby gifWhat is IRR / Internal Rate of Return?

Let’s get this out of the way: IRR sounds boring. 

It sounds like one of those metrics that online real estate gurus dug up from some decades-old finance textbook so that they could sell courses.

It sounds like something you don’t actually need to know to make money in real estate, even though it might come in handy every once in a while.

To be honest, by and large, those guesses are not too far from the truth.

But rest assured you can use IRR for every rental property you’re thinking about investing in. Its utility as a key metric in real estate investing is massively underrated, and you can use it to show your friends and colleagues that not all investments are as good as they appear.

Two Things to Know About IRR

The first—and arguably most important—thing to know about IRR is that it takes the time value of money into account. The time value of money, or TMV, is a popular and widely accepted notion in finance that a dollar today is worth more than a dollar tomorrow.

Most economists and financial advisors believe that this is true for a myriad of reasons: every day inflation eats away at the purchasing power of your money, you could miss out on certain opportunities if you don’t have any cash on hand, you can’t cover emergency expenses without reserves (and borrowing that money could incur massive interest over time), among others.

However, when you use IRR to measure your investment, it takes this enormously important factor into account by setting the net present value to zero. This way, later distributions carry less weight.

Also, IRR is an annualized figure, which means it measures year-over-year performance. In the next section on the difference between IRR and ROI, we’ll show you an example of how ROI can mislead investors into believing that an investment performed better than it really did.

As a quick recap:

  • IRR takes into account the time value of money, which states that a dollar today is worth more than a dollar tomorrow.
  • It’s also an annualized figure, unlike ROI.

Internal Rate of Return: IRR: tennis playerHow Does IRR Differ from ROI?

If one of your friends told you that he earned a 170% ROI upon the sale of his investment property, your first inclination would be to think, “That’s a great investment,” right? 

What if you learned that he bought the rental property in 1990 and sold it in 2020?

Not as great sounding, now, is it?

Over the course of 30 years, that 170% return isn’t as impressive as it sounded at first. Assuming he actually factored his maintenance, taxes, and closing costs into account, your friend fell short of beating even the most basic and easily accessible stock market index. In that same 30-year period, the S&P 500 delivered an 864% ROI (with dividends reinvested: 1692%). He underperformed ten-fold.

However, if he bought the property in 2019 and sold it in 2020, anyone would be in awe of those 170% returns.

Exact same ROI, totally different investment performance. Why? Because ROI doesn’t take time into account. That’s one of the key ways in which IRR differs from ROI. You can use IRR to compare your investment properties to the expected returns of other assets you might be interested in buying, like REITs, ETFs, commodities, and more. You can’t do that with ROI (at least not to the same extent.

Internal Rate of Return: IRR: money spiralHow to Calculate IRR

Before Excel spreadsheets and financial calculators, IRR wasn’t very popular. The formula isn’t easily understood, so we recommend you simply plug the numbers into an existing online IRR calculator.

With that said, we’re going to give you a quick overview of what IRR might look like for an average $300,000 rental property that you plan on owning for 10 years before you sell. To make things easy, we’ll assume you buy it in cash.

Let’s say it’s a duplex and each side rents for about $800 and increases to $1000 over your timeframe.

Initial Investment: $300,000

  • Year 1: $19,200
  • Year 2: $19,200
  • Year 3: $19,200
  • Year 4: $19,200
  • Year 5: $21,600
  • Year 6: $21,600
  • Year 7: $21,600
  • Year 8: $21,600
  • Year 9: $24,000
  • Year 10: $24,000

Then, you earned $100k after selling your rental property for $400k. All in all, you earned $311,200. That’s more than a 200% ROI. Your IRR ends up being 9.09%.

You can play around with the numbers above to see how IRR accounts not only for how much money you earn but also when you earn that money. If for some reason, you expected to charge higher rent for the first few years and lower rent for the last few years, the metric would drastically change to reflect that.

Internal Rate of Return: IRR: tennis player womanConclusion: Why You Should Know Your Property’s Internal Rate of Return

A property’s IRR is important because it takes into account the time value of money in an annualized way. A 200% ROI sounds good until you learn it took place over the course of 40 years, and there are tons of other investments that would’ve outperformed it by a mile.

By calculating your rental property’s IRR (or its assumed IRR), you can accurately compare the investment to those in other asset classes, like commodities or ETFs.

 

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