What is IRR in commercial real estate?
Internal rate of return, or IRR, calculations provide commercial real estate investors with a yardstick for measuring their property investment returns. The IRR on an investment is the percentage at which the net present value (NPV) of a project’s cash flows, both negative and positive, equals zero. Using IRR, a commercial real estate investor can decide if the return from an existing investment is adequate. Investors can also use a projected internal rate of return calculation to assess the profitability of a new property investment.
Think of the internal rate of return as a financial tool that can help commercial real estate investors evaluate the returns from an existing investment property or decide about one they are considering. To understand how the IRR computation works, it is essential to know the concept of net present value. The two are interlinked, and we will discover how they relate. We will also explore how the internal rate of return calculation differs from a couple of other commonly used financial metrics-compound annual growth rate (CAGR) and return on investment (ROI).
IRR vs Net Present Value
This section addresses how the internal rate of return is related to net present value. Consider a commercial real estate investment that involves an outlay of $1 million. This investment yields an annual return of $50,000 for the next five years. Finally, at the end of the fifth year, the property is sold for $2 million. Here is the same information in the form of a table.
Cash flows in a commercial real estate investment
| Timing of the cash flow | Amount | Negative or positive cash flow |
| Year 0 | $1,000,000 | Negative |
| Year 1 | $50,000 | Positive |
| Year 2 | $50,000 | Positive |
| Year 3 | $50,000 | Positive |
| Year 4 | $50,000 | Positive |
| Year 5 | $50,000 | Positive |
| Year 5 | $2,000,000 | Positive |
You will see a negative cash flow in Year 0 and positive flows in Year 1 to Year 5.
But the cash flows take place at different points in time.
The net present value of each cash flow is calculated by applying a discount rate to every inflow and outflow. The computation uses the cost of capital as the discount rate. After this calculation is completed, you will get the net present value for the investment. If the NPV is more than zero, the investment is beneficial from a financial perspective.
In other words, an investor should favorably consider a project that yields a positive net present value when all the cash flows are discounted at the project’s cost of capital. So, where does the internal rate of return fit into all this? The IRR is the discount rate at which the project’s NPV equals zero.
This post will later explain the formula that illustrates the relationship between net present value and the internal rate of return.
IRR vs Compound Annual Growth Rate
The compound annual growth rate, or CAGR, is another commonly used financial metric when comparing commercial real estate investments. An investment property’s CAGR is calculated by comparing its future and initial values. The figure that is arrived at is converted into an annual percentage.
Bear in mind that the CAGR does not tell you how much an investment has grown each year. Instead, it tells you the average rate at which it has grown over the investment period. IRR calculations are more complicated as they consider positive and negative cash flows to arrive at an annual return.
IRR vs Return on Investment (ROI)
The return on investment, or ROI, measures an investment’s profitability. It is expressed as a percentage. Consider a $1 million real estate investment. The investor holds on to the property for five years and sells it for $2 million. The ROI is 100%.
You need to understand a crucial aspect of the ROI calculation. It does not consider the investment period. In the above example, you would get the same ROI if the property was sold after ten years instead of five. As you can see, the ROI calculation is far more straightforward than the internal rate of return calculation.
How to calculate Internal Rate Of Return (IRR)
The internal rate of return gives commercial real estate investors a percentage that tells them the annual growth rate of their investments. However, in technical terms, the IRR of a project is the rate of discount at which the net present value of all the cash flows is equal to zero. In other words, it is the rate of discount at which the cash inflows are equal to the outflows.
This section of the post provides the IRR formula and follows it up with an example.
IRR formula
Here’s the IRR formula:
NPV = Net present value
Ct = Net cash inflow during the period t
C0 = Total initial investment costs
IRR = Internal rate of return
t = The number of time periods
It is not practical to compute the internal rate of return manually. However, it is essential to know how the calculation works. Simply put, the IRR calculation tells you the annual interest rate at which the initial investment grows. The formula reproduced above is solved for IRR while considering the NPV to be zero.
You can determine the internal rate of return of a commercial real estate investment by plugging the variables into Excel or by using Google Sheets. Both are spreadsheets that can function as IRR real estate calculators.
IRR example
Consider a real estate investment that involves an outlay of $1 million and provides inflows of $100,000 in Years 1, 2, 3, and 4. Additionally, the property is sold for $2 million in Year 4.
You can calculate this transaction’s internal rate of return by plugging the numbers into a Google Sheet. The following screenshots illustrate the IRR calculation:
Calculating IRR on a Google Sheet
As you can see, the internal rate of return works out to 27%.
What is IRR used for?
Commercial real estate investors can use the projected internal rate of return to evaluate a project’s potential profitability. This financial metric is beneficial as it allows investors to consider the project’s future cash flows on the dates on which the flows are expected to occur.
Furthermore, when working out the IRR in Excel or a Google Sheet, you can enter both negative and positive cash flows. This allows investors to get an accurate estimate of the return they can expect to earn.
But why should you enter a negative cash flow mid-way through the investment period? Let’s say you incur repair or refurbishment expenses on your commercial property in the second or third year after the purchase. In this situation, you would have an initial negative cash flow (the purchase of the commercial property), a few positive flows (the rent received), and a negative cash flow for the repair expenses. This would be followed by more positive flows for the subsequent monthly rent payments.
Commercial property investors have several other metrics they can use to assess the worth of a project. Among the commonly used commercial real estate valuation methods are cap rates, ROI, and net operating income (NOI). However, the internal rate of return is one of the more accurate ways to evaluate an investment property. You should keep in mind that IRRs are used both to evaluate existing projects as well as to estimate the profitability of a proposed commercial property investment.
Benefits of IRR
The internal rate of return is considered a preferred financial metric in real estate investing. One of its biggest plus points is that the calculation considers the time value of money. In the calculation, the future value of each cash inflow or outflow is discounted to arrive at an NPV.
Some of the other metrics routinely used by commercial real estate metrics do not consider the time value of money. ROI, for example, can tell you the return you have made from an investment property, but the calculation does not look at when the money is received. The ROI would be the same if you double your money over two years or ten. That is hardly an accurate way of measuring real estate investment returns.
Profitability evaluation
The internal rate of return is a crucial metric in commercial real estate investing. One number – the IRR percentage – tells you the rate of growth that a commercial property investment has made. You can also use IRR to evaluate the profitability of a project you propose investing in.
Various investments comparison
While you can use the internal rate of return to evaluate a commercial property investment, this metric can also be applied to other forms of traditional investment. As a result, the IRR can be used to compare different investment categories.
Comparing investments with uneven cash flows
Another significant advantage investors get by using the internal rate of return to evaluate projects is that the IRR calculation supports investments with an uneven cash flow. Consider a bond that gives you a steady return month-on-month and year-on-year. You may not need a sophisticated financial metric like the IRR to evaluate the return you are earning.
However, commercial real estate investing is a whole different animal. You need to contend with:
- Uneven cash flows (changes in the monthly rent)
- Periods when you would not receive any cash inflow (vacancies)
- Negative cash flows (expenditure on repairs)
All in all, the IRR is a financial metric perfectly suited to evaluate commercial real estate investments.
Limitations of IRR
While the IRR is an excellent financial metric for evaluating commercial property deals, it has its limitations.
Ambiguity in reinvestment assumptions
When you calculate the internal rate of return on a commercial real estate transaction, you get a percentage representing your annual return. Although the figure you have worked out in Excel or a Google Sheet is correct, it is based on an assumption that is central to the calculation.
The IRR computation assumes that cash flows from the project are reinvested at the same rate.
What if the inflows are reinvested at a lower rate? If this happens, the project’s return will be lower than your calculated IRR.
Ignores the magnitude of cash flow
Investors should not view the internal rate of return in isolation. Consider comparing two investments. Both give an IRR of 15%, but the first is for a $1 million project, and the other is for one of $5 million. The second will clearly yield a far greater profit. Hence, an analysis that looks only at the internal rate of return could be deceptive.
Sensitivity to cash flow timing
Calculating the IRR in Excel or a Google Sheet allows you to enter negative and positive cash flows, which is an advantage considering the nature of commercial real estate deals. However, there is a catch.
If the cash flow alternates repeatedly between positive and negative, the calculation could throw up more than one discount rate that meets the zero net present value condition. Consequently, the IRR you see could be misleading. So, you must be careful when using IRRs to evaluate investments with cash flows that switch back and forth between positive and negative.
Does not factor in the risk of an investment
Investors should be careful about unthinkingly selecting a property investment just because it has the highest IRR. Remember that the internal rate of return does not consider the project’s risk. For this reason, a property investment with the highest IRR should not necessarily be the first choice when deciding between various alternatives.
What’s considered a good internal rate of return?
To answer this question, you should consider two factors. First, ascertain your cost of capital. Any commercial property with a return lower than this threshold would lead to a loss and should be avoided.
There is also a second factor that you need to think about. What is the opportunity cost for your funds? Can you deploy your investible resources elsewhere, say in a more traditional investment, and make a higher return? Now, examine your options and choose the property with the highest IRR.
The bottom line
The internal rate of return is the best financial metric for analyzing a commercial property deal. It works equally well for existing investments and new projects. However, investors should not use IRRs in isolation. Other factors, like risk, must also be considered in real estate investing.
