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Internal Rate of Return for Landlords
For all of us mere mortals, the term internal rate of return, or IRR, is a little intimidating to say the least. But don't think you have to be Mr. Einstein to figure it out and use it. So, let's put on our thinking caps for a minute and figure out the basics of what the concept of IRR is and how we can use it.
In its simplest form, IRR is the rate of return that can be earned on invested capital, i.e. the yield on the investment. If we invest our money in a bank savings account, the monthly interest that the bank pays us each month is really the IRR on that money.
If a bank pays 4% annual interest on a savings account, then the annual IRR earned on the account is 4%. Applying IRR to a simple Real Estate Investment
Now that we have a basic feel for what IRR is, lets see how it can be applied to a real estate investment...
Example: Jonathan Smith sells a parcel of land for $200,000 that he bought 4 years earlier for $100,000 (a nice profit!). Anyway, to simplify this example, let's assume that Mr. Smith paid no carrying costs (mortgage, taxes, insurance, etc.) and had no transaction costs (points, etc). The internal rate of return that Mr. Smith earned on his original $100,000 investment is roughly 19%. This is the annual rate at which compound interest must be paid for the initial $100,000 investment to grow to $200,000 in 4 years.
An investment property is a good investment proposition if its IRR is greater than the rate of interest that could be earned by alternative investments (investing in other rental properties, buying bonds, or even putting the money into a bank account). Depending on the investment, the IRR should also include an appropriate risk premium.
The "Whiz Kid" Definition of IRR Explaining the IRR in mathematical terms is a little geeky. For the curious souls, it is defined as the interest rate that makes the net present value of a series of future cash flows equal zero. Whew, for those of us who aren't accountants, that’s where the confusion comes in!
To cut through the fog and understand this definition, lets resort back to our savings account example and see how we can apply our definition to it. The future cash flows (in the definition) are the monthly interest payments that the bank will pay on the savings account. If all of these future payments are added up, the interest rate (in the definition) that would make them equal the initial savings account deposit (present value) is the internal rate of return.
Or, in finance terms, the internal rate of return makes the net present value (NPV) of an investment equal to zero. This happens when all future cash flows (summed up) equal the original investment amount.
Method for finding IRR
The following is an example of how to find the IRR of an investment. In this example, $100 is initially invested and produces a cash return of $120 on the investment one year later.
Calculation of IRR:
NPV = 0 The bottom line is that for the majority of residential landlords, understanding the concept of IRR is "a luxury but not a necessity". But for those who put the effort in to understand it, IRR can be another tool that can be used to improve their investment results.
For additional information on how internal rate of return is applied to investment property, visit The Landlord's Library book collection. It contains all the in-depth information you'll need on the subject of residential landlording, information that will make your journey as a landlord much more profitable and rewarding.
Return from Internal Rate of Return to Real Estate Cash Flow
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