Internal Rate of Return - In Layman's Terms

Internal rate of return (or IRR) is generally one of the more popular rates of return used by real estate investors trying to measure a rental property's financial performance because it calculates for time value of money. Therefore, because it provides an association between the present value and future value of the income stream, it allows the investor to take into account both the timing and the scale of cash flows generated by the income-producing investment property.

Okay, that's a mouthful, but bear with me. This article really will attempt to explain what internal rate of return is in a manner you and I are more apt to understand.

Here's the idea. IRR is all about the rate of return the investor can expect on the capital he or she invested to purchase a rental property based upon anticipated future income streams. Namely, that future income divided by initial investment equals rate of return.

But in this case, rather than simply dividing the amount of those future income streams by the amount of investment, IRR applies a "discount rate" in order to compute the "present value" of that future income before dividing by the investment.

A simple illustration will help explain why that's significant.

Say that you were given the option to collect $10,000 today or wait to collect it one year from now. Which option would you take? Of course, you would take the $10,000 today because you undoubtedly understand that inflation erodes purchasing power over time and in one year, $10,000 will not buy you as much goods as you can buy with that same amount today.

Internal rate of return deals with that same assumption, and as a result, considers the "present value" of projected income streams, not just projected (unadjusted) income streams. Let's consider another example.

Assume Investment Rate Of Return is invested to purchase a rental property that over one-year produces a cash flow of $5,000, moreover, at the end of that same year the property is expected to sell for a gain of $20,000-in other words, a future income projection totaling $25,000. However, rather than simply dividing the $25,000 by $100,000, which in this case is 25.0%, IRR first discounts that future income and then does the math. For example, at a discount rate of 10%, the present value of the future income becomes $22,727, and when divided by the investment yields a 22.73% rate of return.

Do you see the difference? Whereas the first method-not discounting future income streams-computes a twenty-five percent return, the internal rate of return method-discounting future income-computes noticeably less of a return, and certainly one closer to reality.

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