Essential Real Estate Calculation #3: Internal Rate of Return (IRR)
For investors that aren’t already familiar with Real Estate Syndications, it involves multiple investors pooling their capital together to purchase no-hassle, hands-off investment properties that deliver passive income and appreciation to the investor. For additional details on real estate syndications, we recommend checking out the following blog posts:
One of the keys to selecting a great real estate syndication investment is performing due diligence and detailed analysis on the Sponsor, Market, and the Property. Our team here at Limitless Investing independently reviews every syndication opportunity prior to sharing with our investors to ensure they are only receiving high-quality, pre-vetted opportunities.
With that said, we believe it is important for investors to understand the Essential Real Estate Calculations that are utilized as part of this analysis. In previous posts we reviewed Net Operating Income (NOI)and Cap Rate. Today we will be exploring the third calculation: Internal Rate of Return (IRR).
What is IRR?
The Internal Rate of Return (IRR) is the expected compound annual rate of return that will be earned on a project or investment. The higher an IRR the more desirable a project is to undertake which allows investors to easily compare multiple investment opportunities.
IRR is also known as "economic rate of return" or "discounted cash flow rate of return." The reason it’s called "internal" is because it leaves out external factors like the cost of capital or inflation.
Why is IRR important?
IIR is the most widely used rate of return measurement by real estate investors because it allows you to take into account both the timing and the magnitude of income produced by your real estate investment.
The timing of income is critical as the quicker you can receive it, the better, as you are able to redeploy that capital to other investment opportunities that can also earn a return. Because real estate investments provide two sources of cash flow (rental income and equity appreciation upon sale), IIR is an ideal measuring stick as it incorporates numerous inputs into a single percentage. Real estate properties that can quickly raise rents through value-add improvements and thus be sold at a profit, are a great example of an investment opportunity that provides a strong IRR.
How do I calculate IRR?
The calculation for IRR is relatively complex:
Luckily, Excel and online tools make calculating the IRR easy. They do all the necessary work for you, arriving at the rate of return you are seeking to find. All you need to do is input initial investment and your projected cash flows.
For example, let’s say you invest in a real estate syndication that provides with the following profile:
$50,000 initial investment
7% cash flow per year from rental income ($3,500 per year)
Property sells in year 5 for double the original investment (original $50,000 + $50,000 profit)
Using the calculator we can see this results in a 20.347% IRR:
Using this same example, but moving the property sale up to Year 3, results in an IRR of 31.685%, an increase of 11.338%!:
As we can see, the timing of the cash flow from potential real estate investments is critical when evaluating which one is the stronger opportunity.
You are now armed with one of the most essential real estate calculations. If you’d like to explore how no-hassle, hands-off real estate syndications can offer attractive cap rates, don’t hesitate to reach out to discuss your investing goals and subscribe to our blog for future content!
If you’re interested in learning more about investing in a real estate syndication, download your free copy of our eBook, Achieving Financial Freedom by Investing in No-Hassle, Hands-Off Real Estate