The Internal Rate of Return (IRR) is one of the most commonly used financial measures in real estate investment, and one of the least well understood. Brokers will bandy the term around freely, but if you ask them just what it means they’ll likely demonstrate why they are brokers rather than investors. Then again I wouldn’t be surprised if half the REIT acquisitions executives couldn’t really explain the concept. So without further ado let’s get one up on the majority of the real estate profession and take a look at what IRR is all about.

A real estate investment is just an income stream, typically made up of a combination of rent and proceeds from the sale of a property at the end of the investment term. This income stream is a series of cash flows which you add together to calculate the total cash you will get.

However, money that you will get in the future is worth less than money you have today since you can instantly start getting a return on any money you have in your hand today i.e. if you have $5m today you can put it in an investment and get cash, but if that $5m is coming to you only in two years time it is not $5m of Present Value. You should discount it by the amount of interest that you could have got if you had have invested the money for two years. This interest rate is the Discount Rate.

Let’s look at an example to make this demonstration of the time value of money explicit. If you could find a similar investment for 10% per annum today, then that means you should discount money that you will receive in two years by 10% per annum, and that means that $5m of cash in two years is equivalent to $4.132m today.

Just in case you are still struggling to grasp the concept, consider that I have $4,132,231.40 to invest today and can get 10% annual return. In one year my investment will grow to $4,545,454.54, then if I reinvest that for a further year it will grow to $5,000,000. So given these conditions if someone is offering me $5m in two years then I would not want to pay more than $4,132m.

Now when we apply this to real estate it means that if I know the future cash flows and I know my discount rate, then I know what the present value of the investment is, and that’s what I’d be willing to pay. We usually use what an equivalent real estate investment will pay as the discount rate.

Now with these fundamentals established we can look at the Internal Rate of Return. But what would happen if I knew the future cash flows, and I knew what I’d be willing to pay for them, but I didn’t know my discount rate? In this case I would calculate the discount rate, and I would call it an IRR. Yes, that is all the mysterious IRR is – the discount rate at which the sum of your cash flows equal the initial cash investment. The IRR is just solving for your discount rate when the two other variables are known. It is a single rate which when applied to all the future cash flows they come to equal your initial cash investment.

One thing to note is that if you have financed your investment in real estate then the IRR is only applied to the equity portion of the investment since it is a measure of return on cash invested and cash received. And by the same token the IRR only measures the actual cash you get back after the debt payments have been made.

Investors like IRR because it takes into account both the timing and magnitude of investments. Because of these duel inputs the IRR can tell you how long to optimally hold a property: the longer you hold a property the further away the sale proceeds, which are usually a big boost to IRR, and thus even if property value increases each year if it does not increase by a decent rate then an early sale could be preferable to waiting for full property value to be reached. The IRR is very sensitive to timing, and long term investors such as pension funds often prefer to consider the equity multiple (see footnote) as one of their key investment indicators.

However, the internal rate of return doesn’t tell the whole story and should be used in combination with other measures of real estate performance. For example, if you have an investment that has costs later rather than just earlier, investments with a higher internal rate of return may be worse than those with a lower one. The reasons for that can be read here at the perils of the IRR, and if you understand that article you are well beyond the Internal Rate of Return for Dummies!

Footnote: The equity multiple is the sum of the total money (distributions and any appreciation upon sale) returned to an investor over a hold period divided by the investor's initial investment.