Internal Rate of Return and Real Estate Investments

The internal rate of return is a very valuable indicator when assessing numerous potential real estate investments. Real estate investors have a finite amount of capital to invest, thus choosing the right investment property to purchase among numerous candidate properties is essential.

The Internal Rate of Return is an indicator that measures the efficiency and desirability of an income-producing property. It is normally used to rank several prospective income-producing properties an investor is considering. Assuming all other factors are equal among the various properties, the property with the highest Internal Rate of Return would probably be considered the best. Most investors employ the use of real estate investment software to calculate the Internal Rate of Return.

When applied to real estate investments the internal rate of return or IRR calculation uses the initial amount invested in the property, a series of projected cash flows, which are usually after-taxes, and a projected after-tax sales proceeds amount in a given year.

The following values have an impact on the Internal Rate of Return calculation:

-INITIAL CASH INVESTMENT
-ANNUAL CASH FLOW
-SALE PROCEEDS

The initial cash investment usually includes the down payment and closing costs, the annual cash flow includes the monthly rent and interest earned, and the sale proceeds is the projected amount the investor plans to sell the property for in a specific future year.

The Internal Rate of Return is a trial-error calculation, which finds the sum of:

Initial Investment = The Net Present Value of Year1 + The Net Present Value of Year2 + The Net Present Value of Year n...

The higher the Internal Rate of Return the better. The higher a project's internal rate of return, the more desirable it is to undertake the project. Real estate investment software often allow investors to specified the benchmark level by which to accept or reject a property based on the Internal Rate of Return specified by the investor.

Additionally if the internal rate of return is less than the cost of borrowing used to finance the property, the property will clearly be a money-loser. That's why most investors will insist that in order to be acceptable, a property must be expected to earn an Internal Rate of Return that is at least several percentage points higher than the cost of borrowing. Investors should always try to purchase a property with a higher Required Rate of Return.

Calculating the Internal Rate of Return manually can be excessive and error-prone; modern real estate investment software better suits this task. Rapid and accurate calculation of the Internal Rate of Return can be the difference between buying a cash-producer from a money-loser investment property.