Using Internal Rate of Return to Evaluate Real Estate Investment Risk

Internal rate of return (IRR) is a popular metric used by real estate developers to assess the risk of their investments. After all, the metric can assess the performance, both existing and prospective, of real estate projects, helping you with budgeting and key decision making. And let’s face it, there just aren’t that many viable tools for this market, which can be quite complex.

However, the tool is imperfect, in part because results are based on assumptions, and because it leaves out key factors. In that light, let’s look at using the internal rate of return to gauge real estate investment risk.

About Internal Rate of Return

The basic definition of internal rate of return is right there in its name: the tool is a way of calculating the “rate of return” of an investment, current or potential. 

IRR, which is stated as a percentage, provides traders with a good estimate of how much money they can predict to make on average and over time from a particular investment

What is the Basis of IRR?

The internal rate of return is centred around two key terms: profit and time. The definition of “profit” here is intuitive, in that it means any earnings that exceed the sum of the initial investment, and fewer investment costs such as property taxes or ongoing maintenance. 

Whenever it pertains to IRR estimates, the phrase “time” is a little more complicated. This is because marketplace variables, like as prices and property patterns, can reduce the predictability of IRR returns. Then again, $50 now isn’t worth the equivalent as it was 20 years ago, and it won’t be worth the same as in 20 years. It indicates that the price of the currency, and thus earnings, will unavoidably shift over time.

What’s Good About the Internal Rate of Return?

For one thing, as imperfect as it is, it is good that the tool exists. Unlike with stock market investments, which can be easily checked with a call to your broker or a few clicks on the computer, there are no such straightforward methods for assessing real estate projects. So, there is that.

It’s also beneficial that the internal rate of return takes into account the time worth of cash (TVM). While examining the worth of money from the viewpoint of “time,” every cash flow is valued the same because all prospective cash streams are considered in the computation.

What’s more, the calculation is simple, even if the formula is complicated. All you need is Excel, an online financial calculator, or a special IRR calculator to get results. 

We’ve mentioned that internal rate of return helps with priorities, because you may evaluate projects based on their likelihood of success. The tool even can be used to size a project up against another type of investment altogether.

Also, it’s a plus that the metric can be used in tandem with another tool so that you can compare the IRR result to other business factors.

Where Does the Internal Rate of Return Fall Short?

Well, because the value of capital is not an integral part of the equation, internal rate of return can produce only a partial view of the future.

Also, because IRR only compares cash flows to the amount spent to produce them, there’s no consideration of a project’s scope or size.

In addition, the internal rate of return does not factor in significant prices that may affect future projects. Those costs can contain, say, fuel and maintenance.

An additional disadvantage is that the internal rate of return doesn’t take redemption rates into account. Even so, assuming that the worth of prospective cash streams may be deposited at the same pace as the internal rate of return, as IRR assumes, isn’t always practicable.

The bottom line is that while the internal rate of return is very helpful in terms of helping investors make important decisions, it does have its downfalls, as you can see. So, if you’re going to use IRR to evaluate real estate investment risk, it’s important to know where it falls short, and then go from there. To fill in any gaps, you may even want to use IRR with a complimentary tool.