# What is IRR? How does it calculated?

- I have read IRR (Inernal Rate of Return), but doesn't know how is it calculated and what does it mean?
- In Buying Property - Asked by city w. - Feb 3, 2011

#### Answer(s)

IRR is the return based on the interest rate of your borrowing cost taking into consideration the initial outlay of your investment and then consequently adding the cash flow typically over a 10 year period. You can benchmark your return in relation to the 10year bond, corporate bond rates, non taxable municipals bonds, and ofr course your want it to be more than your borrowing cost over the investment period of the loan. MIRR is similar but slightly different in that it it does not calcualte the initital negative output for the property purchsase

I feel like this may be a bit of a complex answer for a simple post but I will give it a shot. IRR for an investment is the percentage rate earned on each dollar invested for each period it is invested. It isolates the return portion of the total amount of money recieved from the investment over the holding period and the return is dependent upon both the amount recieved and when it is recieved.

Calculating it is not as easy as understanding the above. Here is how I would go about it. Set up a T-chart with N (number of periods) on the left and dollars(amount of money (out) or recieved for the specific period including the final period and sales price). You then either need an online calculator or financial calculator to solve for the interest portion of the equation. This goes a bit beyond entry level finance and truly requires a grasp on both concept and application and unfortunatly I dont know if there is an easier way I can describe it.

IRR stands for Internal Rate of Return. It is the Discount rate that makes the NPV of all cash flows equal to zero.

It is not possible to type the formula here, but you can find it readily on-line. There are problems with using IRR to measure investments exclusively as it has an assumption that cash flows will be reinvested at the same rate, this is not always possible and can inflate the actual return. It is just one tool to be used.

The IRR, a simple way that I calculate the Internal Rate of Return on a real estate investment for quick synopsis is: I divide the net cash before taxes by the purchase price. Resulting in the quality-grade of your investment. The higher the IRR the lower the quality-grade of the property that will break or yeild very little cash flow to the invest. 1% or less most likely high quality standard real estate in a working class community. Below 1% is most likely Premimum Real Estate with negative cash flow. Above 1% may be cash flowing but have a number of other management problems such as high tenant turnover, in need of repairs due to deferred maintanence . . . etc. That is an acurate rule of thumb to measure and calculate the IRR. I is an answer you are looking for when you or your accountant goes through an accounting speard-sheet; after calculating all the cost to operate the property on annually; and, I think it is only calculated when using financing; not when purhasing for cash.

City Wide.....I am not sure who is asking the question, but unless you are doing large projects, that will be held over an extended period of time (10 years makes a good IRR analysis), and you can fairly project the periodic cash flows, including net cash flow received after paying all sales costs at the time of sale, you might not want to get hung up on IRR. Large institutions and REITs may use this tool, but for the most part it is not widely used otherwise. Some of the larger brokerage houses like to present IRR in their packages. These larger groups have programs whereby the agents simply put in the required data (“projected numbers”) and the program presents them with a nice looking IRR sheet. I have found that in doing transactions up to $20 M over the years that my clients do not ever pay much attention to IRR. They are interested in an approach that says, "Just give me a clear explanation. How much do I have to put in to buy the property, what kind of annual cash flow do you expect me to receive and what will my capital gain be at the time I sell the property, assuming a reasonable cap rate and sales costs at the time of sale?" I find myself doing spreadsheets that present the answers clearly to these questions and never worry about doing an IRR calculation. If you intend to pursue a CCIM designation you are likely to need this, but in the real world of transactions, less likely to be pushed to spending time stewing over IRRs. Good luck City Wide, whomever you are.....Rob Baird, CA RE License #544165 (One of the oldest, active licenses in CA) 951 515-5855 Email: rob@capratecommercial.com

The discount rate at which the net present value of all cash flows (both positive and negative) from a project or investment equal zero.

IRR is calculated using the net present value (NPV) formula by solving for R if the NPV equals zero: NPV= ? {Period Cash Flow / (1+R)^T} - Initial Investment, where R represents the interest rate and T represents the number of time periods. The internal rate of return is a useful metric used to compare potential investments that may having differing time horizons or cash flow patterns. Generally speaking, the greater the IRR, the greater the relative expected return after accounting for the time value of money. However, IRR does not account for risk profile of the expected returns, and thus investors often use IRR as one of several metrics in evaluating potential investments.