What is the Internal Rate of Return?

Internal rate of return, or IRR, is an important commercial real estate metric representative of the annual rate of growth expected to be generated by an investment. Expressed as a percentage, IRR is often used to estimate the profitability of potential investments — technically accounting for the percentage rate earned on each dollar invested for each period it is invested. In a discounted cash flow analysis, the internal rate of return is the discount rate that makes an investment’s net present value (NPV) equal to zero and accounts for the time value of money.

Commercial property investors use IRR calculations to analyze and compare different potential investments to determine which is the most profitable opportunity. The entire purpose of IRR calculations is to identify the discount rate — which is the value at which the present value (PV) of the combined annual cash inflows is equal to the initial net cash investment.

IRR can easily be compared to the compound annual growth rate (CAGR), except that CAGR calculations only utilize the beginning and ending values of an investment, while IRR encompasses different cash flows across different time periods.

IRR Calculator

Calculating IRR

The internal rate of return is calculated in an iterative process using a standard formula. The calculation requires that a few metrics must first be determined. The formula requires an investor to have the net cash inflow, as well as the total initial investment cost metrics on hand along with a given time period — typically a year. Once these metrics have been determined, the IRR can be calculated by setting the NPV’s value to zero in the formula below. Use of a spreadsheet or other software is recommended.

The IRR formula is:

Where,

t = time,

C = cash flow,

r = internal rate of return, and

NPV = net present value.

Important IRR Considerations

What Is a Good IRR?

The nature of the internal rate of return metric leaves its interpretation up to the investor. The major factors that affect how an IRR metric is perceived are the opportunity cost of the investor and the cost of capital. Beyond that, the IRR measurement is typically used as a standard of comparison between potential investments — so really, a good or bad IRR result wholly depends on the IRR of the asset it is being compared with.

When comparing potential investments — considering external variables such as risk or effort remain equal to the investor — the higher IRR represents the ideal choice. That said, it isn’t uncommon for investors to turn down projects with slightly higher IRR measurements that present a higher risk, are more time-consuming, or require more effort from an investor in favor of a less risky or less time-consuming project with a slightly lower IRR.

IRR vs. Modified Internal Rate of Return (MIRR)

Modified internal rate of return, or MIRR, is a variation of the IRR measurement that takes into account any positive cash flow that the investor receives and reinvests into a different asset. MIRR uses the investor’s estimated rate of return on this reinvested cash, known as the “reinvestment rate” to calculate a “modified” IRR that will more accurately represent the investor’s overall return.

Internal Rate of Return and Return on Investment (ROI)

The internal rate of return is often confused with return on investment. ROI, however, represents the percentage increase or decrease of an investment through its entire lifespan — unlike IRR, which instead is a measurement of the annual growth rate. ROI calculations also do not account for the time value of money as IRR calculations do.