Internal Rate of Return Explained: Comparing Real Estate Investment Opportunities

If you're getting into real estate investing, whether you want to buy your own property or take the more hands-off approach of investing with a real estate crowdfunding platform, understanding internal rate of return (IRR) is important to effectively compare real estate investments and choose the most lucrative opportunities.

Here's what you need to know about IRR, how to calculate it, and what else to consider when looking at real estate returns.

IRR is a metric used to measure the return on an investment, most commonly in real estate. It can be applied before making an investment to estimate future returns or after making an investment to calculate historical returns. It's called the "internal" rate of return because it ignores external factors like inflation and cost of capital.

Understanding net present value (NPV)

You have to understand net present value (NPV) to understand IRR. Essentially, NPV is the projected cash flow—cash inflow minus cash outflow—of an investment project discounted to its present value. This is set to zero when calculating IRR.

In other words, IRR takes into account the time value of money. Two investments can return the same amount over the same period of time but have different IRRs due to different distribution schedules.

For example, let's say you put $100,000 into two real estate investments over the course of 5 years. One starts generating positive cash flow in the 2nd year while the other doesn't start until the 4th year. In the end, both return a total of $158,000 on your initial $100,000 investment, just at different times. However, property B offers a slightly lower IRR because it starts generating cash flow later than property A.

Calculating IRR by hand is complex and rarely done. Instead, most people will calculate IRR in excel or using a financial calculator. Now there are plenty of IRR calculators out there you can use to calculate the IRR on any given investment opportunity.

You should consider more than just the IRR of a project when comparing investments, although IRR can be one important factor. You definitely want a positive IRR—a negative IRR indicates you'd lose money on the investment. In general, an IRR of 18% or 20% is considered very good in real estate. For example, many of the commercial real estate investment opportunities on real estate investing app CrowdStreet come with a targeted IRR of 18% or more.

However, higher doesn't always mean better when it comes to IRR. An investment with a 15% IRR over the course of 10 years might be a better investment than one with a 20% IRR over the course of a year. That's because IRR is often more helpful for measuring cash flow rather than long-term return on investment. In the end, a high number over a short period of time is tempting, but the smaller number stretched out over a longer time horizon can be more useful for building wealth.

Return on investment (ROI) is a more commonly used metric that measures the overall return on an investment, whereas IRR measures annual returns. With ROI, it doesn't matter when the returns are distributed. You're looking at the big picture once all returns have been realized.

It's also much easier to calculate ROI, which is simply the return on an investment divided by the cost of that investment and multiplied by 100. In the examples above of the property that costs $100,000 and returns $158,000, the ROI would be 58%. Annualized, the ROI is 9.58%.

You can look at both of these numbers when evaluating a real estate investment. While ROI doesn't factor in when returns are distributed, it's a much simpler and more straightforward way of calculating returns.