What is the internal rate of return (IRR)?

The internal rate of return (IRR) is a financial metric that measures the profitability of an investment over a specific period of time and is expressed as a percentage. It is the discount rate that makes the net present value (NPV) of the cash flow equal to zero.

An IRR takes into account the time value of money, the hold period (i.e. how long you hold the investment for), with the timing of the cash distributions paid to investors both having an impact on the equation.

The higher the IRR, the more profitable the investment (assuming other metrics are also in favour of the investment).

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Let’s look at an example:

Let’s assume the cost to acquire a property is £10,000,000. Assume that £1,500,000 net operating income is received every year. An investor then sells the property for £30,500,000 after 5 years. The IRR on this investment is therefore 15.23%.

The easiest way of working this out is to use the XIRR formula in excel. Simply put, the XIRR formula is XIRR(values,dates, [guess]), where the values are the sum of the 5 year cash flow.

The IRR of 15.23% is then often compared to a company’s hurdle rate or cost of capital. If the IRR is greater or equal to this, it would be a positive factor in helping the company decide if the investment is worth acquiring.

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Pros and Cons of IRR:

One of, if not the biggest advantage of the IRR metric is that it takes into account the time value of money. It is also a metric that can be easily compared against various different investments.

However, while it is a very important metric, it does not factor in the size of the project. Cash flows are compared to the amount of capital outlay generated by those cash flows and can therefore cause a problem when two projects are of different magnitude. The smaller project could have a higher IRR, however it may not be the most profitable.

An IRR is a very common and important tool in real estate, however it should not be used in isolation as there are other factors that can affect a property’s performance. This, and other metrics such as the equity multiple should be taken into account when investing in a property as well as due diligence to assess other risk factors.  

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