1. What Internal Rate Of Return Means To A Real Estate Analysis
Internal rate of return (IRR) is one of the rate of return measurements more widely used during a real
estate analysis for good reason: The aspect of time value of money associated with internal rate of
return considers that the timing of receipts from the investment property can be as important as the
amount received.
Unlike some other popular returns used by investors to analyze the performance and profitability of
rental income properties that don't account for the time value of money such as capitalization rate and
cash on cash, IRR does.
As a result, internal rate of return is generally more popular than other rates of return to a real estate
investor because it calculates for time value of money and provides a linkage between present value
(PV) and future (FV) of any benefit stream.
The idea is straightforward.
Because a dollar in the hand today is preferable to one a year or five years from now, real estate
investors want to take into account both the timing and the scale of cash flows generated by the
income-producing property to determine what that rental income stream is worth today. Internal rate
of return reveals the rate at which future cash flows must be discounted to equal the amount of
investment exactly.
How IRR Works
Internal rate of return reveals in mathematical terms what a real estate investor's initial cash
investment will yield based on an expected stream of future cash flows discounted to equal today's
dollars, not tomorrow's dollars.
Consider this.
When you make a real estate investment, you are investing cash in order to receive a series of future
annual cash flows resulting from rental income plus a tidy profit when you sell the property.
The challenge for real estate investors, then, is to discover what rate of return the investor's initial
equity will make based upon those periodic future cash flows at the same time it considers the
number of time periods (years) under consideration in the holding period.
The internal rate of return model meets that challenge by creating a single discount rate whereby all
future cash flows can be discounted until they equal the investor's initial investment.
How to Calculate
Calculating IRR manually is not practical because the calculation involves tedious mathematical
solutions that take a lot time. Even the most skilled investment real estate specialist will typically use
a financial calculator or real estate investment software program to compute it.
So we'll ignore the formula (you can find it online if you really care to know it) and instead consider
what it signifies.
Say you have $100,000 to invest in a rental income property and plan to hold it for five years. During
those years, you plan on receiving five annual cash flows and then an additional amount from the
sale of the property (also known as reversion). When you find the unique rate of return that discounts

2. the sum of all those future cash flows until it equals your initial investment, you will have the internal
rate of return.
In other words, what your cash investment will yield for those cash flow projections based upon
today's value of the dollar, or as if those cash flows were collected today rather then in the future.
Of course, no single element of a real estate analysis should determine an investment decision to the
exclusion of other factors and measurements. But internal rate of return can help guide your
purchasing decision so plan to use it.
One final thought. If you are serious about real estate investing, then it is highly recommended that
you invest in a real estate investment software solution. In this case, you not only will get a wide
range of essential returns that includes IRR, but also benefit from all real estate analysis features that
quality investment software provides.
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