Private assets such as real estate, however, is another kind of animal altogether. With these, it can be a challenge to determine the expected return. One increasingly popular way to check the potential profitability of real estate investment is through what’s called the internal rate of return – or IRR. Keep reading for factors that determine the IRR of a real estate investment – and more.
Just What is IRR?
Essentially, an IRR is roughly the value property generates during the time you own it. It’s the percentage of interest you earn on every dollar you have invested in a piece of real estate over the whole earning period. You can use this information to calculate the average annual return realized, or that you can anticipate realizing, from your real estate investment. The aim is to marry a measure of profit with that of time to produce a singular metric. How Valuable a Tool is IRR for Real Estate Investors? Because real estate transactions – rental payments, proceeds from the sale, etc. — occur over many months or even years, their relative value is unequal. In other words, today’s dollar isn’t worth the same as it was six years ago. With IRR, though, you can get a more equitable comparison – apples to apples — by assigning a value to cash flows that happen at disparate times. The proviso here is that the initial IRR is, in fact, an estimate. Still, it’s a great tool for gauging a project’s prospective annualized return. You will get the real IRR after the property is sold. How Can Real Estate Investors Figure Their IRR? With an IRR, the aim is to tell you, the investor, roughly how much you can expect return-wise, based on over-time cash flows, and as expressed in a single percentage. Thus, the discount rate must be found because such a rate sets to a net present value of zero all the project’s cash flows. So, if your IRR is negative, that likely means a project on which you might lose money. Figuring out the IRR for real estate investments means making a few assumptions. These include the level of annual distributions, the project’s sale date, and the price at which the project is unloaded. These assumptions will subsequently be weighted relative to the investment’s initial cost. Don’t Rely on IRR Alone A variety of factors can determine a project’s return. Those can include a project’s size or risk profile, the project’s time frame, and the real dollar amount of profit to be realized. However, using an IRR for real estate investments can still be beneficial in that the IRR considers the timing of looming cash flows and weights them accordingly. Plus, particularly when using an IRR calculator, the IRR can be quite easy to figure. Ultimately, an IRR calculation is a projected estimate, and as such, actual results can vary. But now that you’re aware of the factors that determine the IRR of a real estate investment, you know that an IRR can still be a valuable tool in terms of helping you make informed decisions about the location and timing of your real estate investments. If you need more help with this, contact Yieldstreet, which provides alternative investment opportunities – those other than stocks and bonds — across asset classes including real estate.
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