IRR: Internal Rate of Return - Measuring the Time Value of Money in Commercial Real Estate Investments and Developments
The internal rate of return (IRR) is a calculation investors use to determine the likely rate of growth of capital (as it relates to both time and yield) for a particular commercial real estate investment opportunity. Commercial property investors often calculate the IRR to compare different potential investments to determine what is the most profitable opportunity. All other things being equal, the potential investment with the largest IRR is the most lucrative venture.
Calculating the IRR is a common way to evaluate real estate projects of disparate sizes. For example, a $7 million investment that yields $21 million in return has a higher IRR than a $70 million investment that yields $140 million.
The IRR isn't a perfect calculation because it doesn't consider the cost of capital. Also, it can't be used to calculate the rate of return of different projects that don't have exits on the same time horizon. It also doesn't take into account the size of the rate of the return, which should impact the interest of an investor. For example, an investor can choose to invest $20 for a return of $100, which has a much higher IRR than an investment of $20 million for a return of $40 million.
The formula used calculate the internal rate of return is as follows:
Through this formula, we see that the IRR for any commercial real estate property investment is simply the percentage that brings the property's net present value (NPV) to zero. Both IRR and NPV can be used in discounted cash flow (DCF) analysis to determine the current value of a set of cash flows using a predetermined discount rate. That makes it easy for investors to compare the potential investment gains from a commercial property to the potential gains from another investment, such as a stock, bond, or a different piece of real estate.
The internal rate of returns is a key metric when it comes time to defining the relationship between time and yield on a commercial real estate investment. It is most commonly used by investors that have sensitivity to velocity of capital such as merchant builders. Regardless of your investment goals it's important to understand all the metrics as it relates to commercial real estate investment underwriting.