IRR or internal rate of return, allows us to find the return on cash flows across a property's life, including the time value of money. It is an annualized rate of return for multiple periods, unlike cap rate which is used for a simple holding period. Real estate investors are familiar with cap rate as a performance metric. One problem with cap rate is that it's very static. It measures cash flows for a year with no changes in those cash flows. However, we know life changes.
IRR is able to factor in cash flow changes. IRR looks at cash flows across time and will calculate a return based on those cash flows. IRR is able to capture total return, meaning it reflects both income received over time and the sell of a property. For total return, the final sale price is listed in the last year’s cash flow.
The main difference between IRR and ROI (return on investment) is that IRR is time-dependent — cash flows spread out into future periods. ROI is just a division and does not consider the time element.
Calculating IRR by hand is probably something you don't want to do.
Instead, we’ll use Google Sheets to perform the IRR calculation. The calculation is similar in Excel. Below are a couple of examples to understand how it works. In the first image, we have two projects. Period 0 is the initial investment or purchase price. Period 0 is considered a cash flow, but technically, it is a cash out flow. Periods 1-5 are cash flows. The cash balance (row 8) is the net amount after five years, including the initial investment.
Starting with row 9, we begin calculating the IRR:
Now that we have two IRRs for each project, what do these numbers tell us? At first glance, Project B seems to be the better project of the two and the one we should consider moving forward with since it has the higher IRR. We can see that the return on Project B’s cash flows is much higher because of the lower initial investment. Before making a decision, we’ll do a little more analysis. This will come in the next section.
What about NPV? NPV is the net present value of the project. When we plug the IRR into NPV, the result should be zero. This is just a check to ensure our numbers for IRR are correct. The NPV formulas are:
Notice that NPV is only adding the cash flows. That’s because period 0 is current money. NPV wants to calculate only future money. To include the initial investment, we must add it after the NPV calculation.
Without IRR and using more complex examples, it may not be clear from the initial investment and cash flows which project provides a better return. IRR removes the subjectivity, considers the time value of money, and provides a clear distinction.
Where is Risk?
The old adage, the higher your returns, the higher your risk holds true here. Is there any reason to choose Project A? One reason may be that it produces higher cash flows immediately. You recoup more of the initial investment with each period. This is a reduction in risk because you’re receiving more from your initial investment in a shorter timeframe than with Project B.
Project B is loaded to the back-end, which means most of its cash flows come at the end of the project. This is a higher risk project because a large amount of time occurs between the initial investment and recovery of that investment. For this risk, your reward is a higher return. But to realize that higher return, you have to stick with the investment until the end.
In general, the longer the holding period, the more risk there is. This goes back to how much time is there between the initial investment and recouping that investment. We saw with Project A that it begins working on risk reduction right away with large cash flows. But there is still risk as you have to wait until the final period before the full investment is returned. If Project A cash flows were spread out over ten years, all else being equal, it would have higher risks.
Time Value Of Money
The time value of money (TVoM) is taken into consideration when using IRR. The mantra, a dollar today, is worth more than tomorrow still applies. TVoM works better with longer time frames (i.e., multi-year holding periods). For shorter time frames, IRR can skew results.
For example, a 3-month fix-and-flip may have an annualized IRR of 20%, but it's holding period return is only 5%. While this short-term fix-and-flip has a high return, it also presents a lot of risks and may not be worth the trouble.
Not Great For Projects With Irregular Cash Flows
Let’s look at Project A again but this time, with irregular cash flows. This means the cash flows between positive and negative rather than remaining consistently positive. In other words, they aren’t all positive. When this happens, IRR can run into trouble. There can be many reasons for irregular cash flows — a roof or driveway replacement are two common examples. Let’s see what happens to IRR when irregular cash flows are involved.
Period 2 creates an irregular cash flow, but the cash balance doesn’t change for the project. We still have the same $500. But expanding the IRR decimal place reveals a difference in the two projects. Our Project A returned 3.16%, whereas now it is returning 2.80%. Despite what IRR says, ultimately, we are getting the same return at the end of the project. That’s the impact of irregular cash flows on IRR and a good scenario for avoiding IRR.
It's Just One Of Many Financial Metrics
It's important not to lose sight of the fact that IRR is only one of many financial metrics. Just as we don't decide based purely on cap rate, we shouldn't make a decision based purely on IRR. Utilizing several metrics will help paint a more complete picture, resulting in a more informed decision.
IRR is another excellent tool to have available when performing returns analysis on investment properties. It’s one more step towards creating a complete picture and helping you to make a better-informed investment decision.