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What Internal Rate Of Return Means To A Real Estate Analysis
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What Internal Rate Of Return Means To A Real Estate Analysis

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  • 1. What Internal Rate Of Return Means To A Real Estate AnalysisInternal rate of return (IRR) is one of the rate of return measurements more widely used during a realestate analysis for good reason: The aspect of time value of money associated with internal rate ofreturn considers that the timing of receipts from the investment property can be as important as theamount received.Unlike some other popular returns used by investors to analyze the performance and profitability ofrental income properties that dont account for the time value of money such as capitalization rate andcash on cash, IRR does.As a result, internal rate of return is generally more popular than other rates of return to a real estateinvestor 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 estateinvestors want to take into account both the timing and the scale of cash flows generated by theincome-producing property to determine what that rental income stream is worth today. Internal rateof return reveals the rate at which future cash flows must be discounted to equal the amount ofinvestment exactly.How IRR WorksInternal rate of return reveals in mathematical terms what a real estate investors initial cashinvestment will yield based on an expected stream of future cash flows discounted to equal todaysdollars, not tomorrows dollars.Consider this.When you make a real estate investment, you are investing cash in order to receive a series of futureannual 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 investors initialequity will make based upon those periodic future cash flows at the same time it considers thenumber 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 allfuture cash flows can be discounted until they equal the investors initial investment.How to CalculateCalculating IRR manually is not practical because the calculation involves tedious mathematicalsolutions that take a lot time. Even the most skilled investment real estate specialist will typically usea financial calculator or real estate investment software program to compute it.So well ignore the formula (you can find it online if you really care to know it) and instead considerwhat it signifies.Say you have $100,000 to invest in a rental income property and plan to hold it for five years. Duringthose years, you plan on receiving five annual cash flows and then an additional amount from thesale 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 internalrate of return.In other words, what your cash investment will yield for those cash flow projections based upontodays 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 theexclusion of other factors and measurements. But internal rate of return can help guide yourpurchasing decision so plan to use it.One final thought. If you are serious about real estate investing, then it is highly recommended thatyou invest in a real estate investment software solution. In this case, you not only will get a widerange of essential returns that includes IRR, but also benefit from all real estate analysis features thatquality investment software provides.real estate sherman oaks