# What IRR Can Tell Investors About Real Estate Investments

Last year, we wrote a blog post about the basics of the Internal Rate of Return (IRR) calculation. Today, we will explore IRR further. IRR is one of the metrics of choice for many real estate investors because it takes into account the time value of money using discounted cash flow analysis. Investors should think of IRR as the projected rate of growth an investment can potentially generate.

Overview of IRR – What You Should Know

In any investment opportunity, investors are not only interested in how much money they would potentially receive, but when they would potentially receive it. The IRR calculation is a key aid for investors in evaluating investment opportunities because it helps to equate funds flow over different periods to their net present value, thus applying the key underlying concept of the time value of money. This concept holds that a dollar today is worth more than a dollar tomorrow, due to inflation, opportunity cost, and risk.

The IRR is the discount rate that will bring a series of cash flows to a net present value of zero (or to the current value of cash invested). In order to calculate IRR, investors must understand the concept of discounting. It can be viewed simply as compounding interest in reverse – that is, compounding interest working backwards in time. By assigning projected cash flow distributions on a periodic basis (along with any projected gain on sale upon exit/at reversion), we can calculate IRR.

IRR and Real Estate Investments

Evaluating IRR for real estate investments is a very important tool for investors to analyze different projects. It is important to note the advantages and disadvantages of using IRR to analyze real estate investments:

Time Value of Money – The timing of all future cash flows are considered; therefore, each cash flow is given an appropriate weight by discounting the time value of money.
Simplicity – IRR is an easy metric to calculate and it provides a simple means by which to compare various real estate projects.
Hurdle Rate Not Required – IRR does not require the use of a “hurdle” rate (i.e., the cost of capital, or required rate of return at which investors agree to fund a project), mitigating the risk of determining a vastly divergent rate. IRR can be calculated independently of the use of such rates, and investors can then compare their own individual estimated cost of capital to the IRR as they choose.