IRR is the discount rate that makes an investment’s net present value equal zero, in plain terms, it’s the single annualized return that accounts for every dollar you put in, every dollar you get out, and exactly when each one happens.
What is IRR and why does it matter in real estate?
The Cap Rate and Cash-on-Cash Return are great for a quick, first look at a deal, but they both have one big flaw: neither considers when you will get your money back, or what happens when you finally sell the property.
The Cap Rate completely ignores financing. Cash-on-Cash Return includes your mortgage payments in the calculation, but it treats each year of cash flow as equal; a dollar today is worth more than a dollar five years from now.
The IRR solves this problem. It takes into account the rental income, the amount of the property’s eventual sale, and the timing of both in a single number; A number that allows you to evaluate different trades as identical and comparable, even if they differ greatly in terms of investment duration, leverage, and exit strategy.
The IRR Formula Explained
The actual equation looks like this:
0 = CF₀ + CF₁/(1+IRR)¹ + CF₂/(1+IRR)² + … + CFₙ/(1+IRR)ⁿ
It’s more intimidating to look at than it is to actually use.
- CF₀ is what you put in at the start, written as a negative number since it’s leaving your pocket.
- CF₁, CF₂, through CFₙ are what comes back to you each year, your rental income, and in the final year, your net proceeds from selling the property.
- n just marks how many years you’re tracking.
You are not supposed to do this calculation manually. The unknown rate appears in each term, raised to a different power, and cannot be solved algebraically like a normal equation.
What everyone does in practice is to let a spreadsheet or financial calculator do the calculation for them. They keep trying different rates until the entire equation finally equals zero.
You don’t need to know how to do this iterative process, just know what information to give the tool.
How to Calculate IRR: A Real Estate Example
Property value is $1,000,000. Rent is $125,000 a year. You sell four years later for $1,500,000.
Lay your cash flows out year by year:
|
Year |
Cash Flow |
|---|---|
|
0 (purchase) |
−$1,000,000 |
|
1 |
$125,000 |
|
2 |
$125,000 |
|
3 |
$125,000 |
|
4 (rent + sale) |
$1,625,000 |
You put them in Excel or Google Sheets, plug them into the =IRR() function and the answer comes out as 21.6%. And that’s your annualized return all things considered. And that is the truth that your money was tied up in the property for four years before most of your gain finally came through the sale.
Don’t get hung up on matching these numbers exactly to your deal. What matters is the structure, your purchase price in year zero, your rental income in each of the following years, and the amount of sales proceeds you expect to add to the final year. Type your numbers in the same format and the formula does the rest.
What is a good internal rate of return?
There’s no single right answer to this question. It depends almost entirely on how much risk you’re comfortable taking.
Stable, fully rented properties in a good location. Expect around 7-10%.
Medium-risk deals, with some tenant growth coming in or minor improvements needed: typically 10-15%.
Real value-added deals, with real renovations or repositioning: typically 15-20%.
Development from vacant land or anything that is truly opportunistic. It often needs to be 20% or more to be worth taking on this risk.
As a rough guideline, 15-20% is widely cited across the industry as a strong rate for a typical lease or leveraged commercial deal, although a stable, low-risk property yielding 8-10% can also be a really good investment if security is more important to you than the potential for higher returns.
There are two things to remember when you compare your numbers to these ranges: It makes a difference whether you’re calculating the IRR Levered or Unlevered; Unlevered targets are usually less, around 6-11%, because there is no financing to give a bump to the return.
The location and condition of the property also play a large role in this range; an established asset in a prime market can’t be valued on the same scale as a redevelopment project in a growing neighborhood.
Where IRR Applies in Real Estate Investing
Four types of deals in particular tend to send investors looking for IRR specifically.
- Short-term rentals are where this metric is most useful and valuable. Occupancy changes with the seasons, and pricing changes with it, so your cash flow fluctuates from month to month, something a flat annual return can’t accurately capture. IRR is designed for exactly that.
- Long-term rentals also benefit from this metric, but for a different reason. Rental income alone doesn’t tell the whole story; property appreciation and property management costs are also part of the equation. IRR also aggregates all three into a single number, so you don’t have to manage three separate spreadsheets at once and try to make sure the totals add up in your head.
- Development projects are where timing really matters. Your money is completely gone at first, before you get a single dollar back. Then, much later, the returns appear in a lump sum. A simple percentage return easily skips this time gap. But IRR doesn’t.
- If you’ve ever tried to compare a commercial deal with a residential deal, you probably know how apples and oranges it usually is; different lease structures, different holding periods, and nothing is exactly the same. IRR is the same number that still applies to both.
Limitations of IRR
IRR is powerful, but it doesn’t tell you everything a deal needs to reveal. You can see some of its limitations of IRR below.
What Affects Your IRR
- Timing: It does a lot more heavy lifting than most people think. Even if the total dollar amount never changes, your IRR goes up and you get your money back sooner and that’s really the point of the calculation.
- Size of cash flow: This is a more intuitive one but it matters how big your cash flows are. The number goes up with bigger, more stable rental income. It is burdened by thin or unpredictable income.
- Your initial outlay: If the returns don’t scale accordingly, what you put in up front is working against you. Invest more up front without getting proportionally more back, and your IRR takes a hit.
- Holding period: The longer you’re projecting a holding period, the more room there is for your assumptions to be wrong. That’s why longer time horizons actually have more risk here, not because IRR calculates differently.
Then there are the things that you can’t control. Interest rates and inflation alter what a good return looks like from year to year, and they screw with how believable your rent growth and exit price assumptions are really are.
IRR vs. XIRR: What’s the Difference?
IRR assumes the cash flows are at equal intervals, annually, on time. But fine for most simple rental analysis.
XIRR handles cash flows that don’t land on a clean schedule, a renovation cost in month 3, a rent increase in month 14, an early sale at month 19. If your actual cash flows are irregular, XIRR gives a more accurate picture than standard IRR, since it accounts for the exact date of each cash flow rather than assuming equal spacing.
Is IRR the Same As ROI?
No but they are often confused because they both give a return in percent terms. ROI is simply the total return you got compared to the total cash you invested, regardless of when that cash was invested or the period of time it covers.
IRR factors in the time value of money, weighting a dollar received early more than one received later, and annualizes the result so you can compare deals with totally different holding periods.
That distinction matters more than it sounds like it should. A deal that returns most of its profit late, say, the bulk of it landing at a sale in year 8, can post a strong ROI while showing a comparatively modest IRR, since so much of the return took so long to materialize.
