What is IRR?
- It’s the “average yearly growth rate” your investment would need to earn so that the money you invest up front eventually comes back to you—plus profit—when you include income (like rent) and sale proceeds over time.
- It’s shown as a percentage, making it handy to compare one investment to another.
Why Does Timing Matter?
- Money you get earlier is more valuable than money you get later. IRR tracks when you receive the cash flows, not just how much you get in total.
A Quick Example
- Start with $100. You buy a small property for $100.
- Cash Flows: You collect $25 in the first year, $30 in the second, $35 in the third, $40 in the fourth, and $45 in the fifth.
- Finding the IRR: Use a bit of trial and error (or a spreadsheet function) to see which discount rate makes the present value of these inflows add up to $100. In this example, that number is about 6%.
This means your investment effectively grows by about 6% per year, after accounting for how quickly you get your money back.
Why Bother with IRR?
- Comparing Different Deals: It gives a quick sense of whether a property might deliver a faster or higher yearly return, especially when projects have different costs and timelines.
- Hand-in-Hand with Other Metrics: IRR alone doesn’t tell you everything—pair it with Net Present Value (NPV) or cap rate to see the bigger picture.
- Practical Benchmarks: If your IRR is higher than what it costs to finance (your “cost of capital”), you’re probably looking at a decent deal.
CFA Insight
In the CFA curriculum (often used by finance professionals), IRR is introduced as the discount rate that sets the net present value of an investment’s cash flows to zero. The core idea remains the same across all finance contexts—whether for real estate or any other investment:
- All Cash Flows Included: Initial outlay, ongoing inflows, and final sale or payout.
- Annualized Return: IRR is the single rate that captures how fast your cash is “growing” year after year.
- Decision Rule: If an investment’s IRR exceeds your required rate of return (or cost of capital), it tends to be considered a go.
Final Thoughts
- IRR measures how quickly your money is growing, considering the exact timing of each dollar earned.
- Pair IRR with other metrics (like NPV, cap rate, and payback period) to get a well-rounded view.
- The higher (and sooner) the return, the higher the IRR—so think about timing when deciding which deal is right for you.
