How to calculate the Internal Rate of Return and what it means for the real estate industry
For commercial real estate investors and owners, mitigating risk requires making informed decisions based not only on accurate data, but also on the projected return on investment and rate of return. One such tool asset managers can use to assess the value of a given investment is the internal rate of return (IRR) formula.
Even if your current processes and operations include knowing how to calculate IRR, understanding its purpose and how it’s being used in the real estate industry can help guide you in the use of the formula.
What is internal rate of return and why is it important for real estate?
Before investing in a property, real estate investors need to know if that project will deliver profitable returns. In its simplest form, IRR is the percent that an investor will earn if a certain project performs as expected.
This statistic is important for commercial businesses with multiple properties managed by separate parties because it gives a better picture of what your investments might yield, allowing your business to make the determination as to whether a project is worth the time and effort. Calculating IRR requires an input of real data based on real assumptions, which means the data you’re using to make assumptions should be rock solid to ensure accurate results.
How to calculate the Internal Rate of Return
One way to determine the internal rate of return on a project is to calculate it manually by following a set formula. In this formula, the expected cash flows for your investment are given and the Net Present Value (NPV) equals zero. More information on what that formula looks like in practice can be found here, and once the internal rate of return is determined, your business can put it up against the cost of capital to see the financial value of the project based on your new and existing data.
How IRR is used across real estate
Utilizing the IRR formula can help asset managers in real estate businesses not only assess the value of a property now in comparison to other potential investments, but it can help determine the cost of the project over time and in response to different potential scenarios.
However, most property management systems don’t have the ability to calculate IRR in-system, which leads users to export data from the system into a third-party application, calculate IRR, and then reupload data into their property management systems. Many times, that system can be as unstructured as an excel spreadsheet. The danger in doing this, however, is that the data you plug in to calculate the Internal Rate of Return needs to be as accurate as possible, and whenever you export data into a third-party application that doesn’t integrate with your property management system, errors can come into play quickly.
This problem is exacerbated by the models that many asset managers operate, where employing multiple managing agents means that they have to manually model IRR from multiple disparate data sources. This makes forming a true comparison of IRR across different assets a challenge, often consuming the time and effort of at least one staff member per year.
For asset managers in the real estate industry, knowing how to calculate IRR is becoming an important part of the job. Calculating IRR with a tool that doesn’t integrate with your processes, however, can create increased risk for your business. Learn how MRI Investment Central can integrate with your property management system, keeping all your data on the same track and giving you confidence in your calculations.
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