Calculating The Internal Rate of Return On Your Investment
In finance, particularly capital budgeting, analysts use the internal rate of return to estimate the profitability of investments. The internal rate of return is the discount rate that makes the net present value of all cash flows from a particular period equal to zero. The net present value is the value of a property’s expected cash flows minus the initial investment. Project or property owners always want to have a positive net present value, as a negative net present value indicates the project is under performing. When you set the NPV to zero to calculate the discount rate or the IRR, you would want to aim for a high IRR. The higher the IRR, the more promising an investment’s monthly cash flow and profitability. In summary, the IRR is the percentage of interest that you will have earned on each dollar you have invested in an investment property over its holding period.
When running an investment property analysis, many real estate investors rely on the return on investment as a measure of performance. The rate of return on rental property can also be calculated using the return on investment (ROI). However, as a real estate investor, you must identify the uses and benefits of the two terms and how they fit your objective. For example, the ROI differs from the IRR in the way the time horizon is weighed in. The ROI measures the performance of a rental property over a certain period of time, whereas the IRR measures the performance of that for shorter durations of time. Moreover, real estate investors use the IRR to calculate the annual growth rate of the investment and ROI to calculate an investment’s returns from the beginning to end.
Ray Martin of The Martin Agency has this advice for investors as a real estate investor, you must know how to calculate the internal rate of return and the steps associated. While there’s no specific internal rate of return equation, the IRR formula uses the definition of the NPV and sets it equal to zero in order to find the discount rate. The discount rate, whereby, is the value that the IRR seeks. The internal rate of return formula can then be calculated by equating the sum of the present values of future cash flows minus the initial investment to zero and solving for IRR. Below is the IRR formula:
N: The total number of years
Cn: The cash flow in the current period
n: The current period
r: The internal rate of return
(Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)2 + Cash Flow Year 3/(1+IRR)^3) -Initial Investment=0
Let’s look at some numbers. Ray Martin who is considering buying a rental property for $100,000, for which he assumed revenues for the upcoming three years to be $10,000 each. So when we plug in the numbers, we get:
($10,000/(1+IRR)^1 + $10,000/(1+IRR)^2 + $10,000/(1+IRR)^3) -$100,000=0
Since we have different exponents, doing the internal rate of return calculation by hand can get long and messy. Therefore, we recommend that you use Excel or an internal rate of return calculator that you can find online.
You may be wondering then how to calculate IRR in Excel. Calculating the IRR in Excel is straightforward and can be summarized in one single step, where the syntax for the formula is given by =IRR (values, [guess]). When you select the IRR formula, you then select future cash flows for the desired period and the cost of the investment, then you get a percentage answer of what the discount rate or IRR of your investment will be.
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