The Internal Rate of Return and Measuring Real Estate Investments

When looking to invest in real estate, it is a good idea to establish a “hurdle rate” or minimum rate of return expected from a real estate investment.  Thus, opportunities that do not meet this hurdle are immediately discarded as not worth the time or investment.  When it comes to establishing a hurdle, many investors like to use an investment’s Internal Rate of Return or “IRR” when analyzing potential investments.

The IRR is the Discount Rate that makes the Net Present Value (NPV) of an investment equal to $0.00 (discount rate and NPV are explained in an earlier blog post titled: The Importance of the Time Value of Money in Real Estate).  To accurately measure an investment property’s IRR, the investor needs to factor in the initial cash outlay and a series of projected cash flows over a specific period of time.  Furthermore, these cash flows should include the cash proceeds from the sale of the investment property (equity reversion) to accurately gauge the IRR.  Once these figures are deduced, an investor can weigh the worthiness of the investment.

For example, let’s say the investor is looking at two single family investment properties in which to invest. The  investor plans to hold on to the investment property for five years.  Both properties would require a 20% cash down payment (outlay) with the remainder financed by the bank with an the assumed terminal capitalization rate of 8.50%.  The investor’s hurdle rate is 12%.  Given these assumptions, we can begin to compare the investments using the following information:

Investment Property A

Total Acquisition Cost (including all closing costs): $208,973
Total Yearly Rental Income: $22,410
Yearly Operational Expenses: $6,750
Net Operating Income (before debt): $15,660

Knowing the initial cash outlay, projected income and projected before-tax equity reversion, the investor is able to determine the investment’s projected IRR, which is 14.01%.  This also creates a positive NPV of $3,114, providing further indication that the investment’s return meets the investor’s hurdle of 12%.  How does a comparable investment stack up?

Investment Property B

Total Acquisition Cost: $229,259
Total Yearly Rental Income: $23,760
Yearly Operational Expenses: $7,000
Net Operating Income: $16,760

Property B, while having a higher net operating income, requires a greater initial cash outlay and thus doesn’t have quite as high an IRR as Property A at equity reversion.  The property also does not meet the investor’s 12% hurdle with an IRR of 11.73%, which results in a negative NPV of $450.  Investment Property A is the better investment based on these assumptions.

While IRR is a great tool to measure the worthiness of an investment property, there are some pitfalls to consider when using IRR.

• IRR cannot measure the reinvestment of cash flows. The reinvestment of cash flows gained from an investment during the hold period would have to be measured using an alternative method.
• IRR does not measure the magnitude of an investment. It looks at $50,000 and $5,000,000 investments the same.  Thus, the amount of cash flow is not taken into consideration.
• Investments cannot have different hold periods when running a comparison. Comparing an investment property with a 5 year hold period to an investment property with a 10 year hold period is not a financially accurate way to gauge the investments.

An investment’s IRR is a helpful tool to determine its worthiness, but shouldn’t be the only figure to rely on when looking to invest in real estate.  When looking to invest, it is prudent to discuss your financial goals with your account or financial advisor.  Whether you’re a new investor ready to dive into the real estate investing world or a seasoned investor looking to expand your portfolio, the team here at Black Diamond Realty has multiple investment properties that could be a fit.  Call us today at 304-413-4350.