How is Internal Rate of Return (IRR) calculated for investment property
Hola! How was IRR calculated? Thank you.
|LM says: Hi there, this is a good question and something important to know when analyzing your investments. I am actually surprised you are the first one to ask this because for many situation, specially for investments held for a significant amount of time the Internal Rate of Return (IRR) can actually give you a better idea of the performance of an investment than the more often used Return on Investment (ROI). |
First off the main difference between ROI and IRR is that the IRR considers the effect of time and compounding while ROI just considers the investment amount regardless of what span of time that money was “tied up” in an investment. To be specific IRR measures the yield or rate of return on an investment rather than it’s present value (1).
Basically the IRR is calculated by considering cash flows over a period of time. So you will consider all the money that was put into the investment and whatever was taken out of it, over a period of time. The problem is that this is a pretty complicated calculation that you will not be able to do on paper…however you can calculate it in a pinch using Microsoft Excel.
If you use Excel 2003 you will use the formula “=IRR(H3:H38,G3:G38)” and in Excel 2007 and 2010 it will be “=XIRR(H3:H38,G3:G38)” where H3 through H38 is the sum of the money in and out and G3 through G38 is the time period for the investment.
You can see an example of the calculation for Excel 2003 here.
So for the specific case here of House #5 I just added the cash flows I had for that specific property over a period of four months (duration of investment) in the Excel formula detailed above and the result is an IRR of 59.53%.
Although IRR can be used just fine for flips it probably is a better gauge of investment performance on income producing properties (rentals) that you hold several years.
Does that answer your question?
(1) "The Complete Guide for Real Estate Finance for Investment Properties" by Steve Berges, P. 113.
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