Internal Rate of Return

The Internal Rate of Return is an indicator that measures the Efficiency and Desirability of a real estate investment property. It is normally used to rank several prospective real estate investment properties an investor is considering. Assuming all other factors are equal among the various real estate investment properties, the real estate investment property with the highest Internal Rate of Return would probably be considered the best.

For a real estate investment property, the internal rate of return or IRR calculation uses the initial amount invested in the real estate investment property, a series of projected cash flows which are usually after-taxes, and a projected After-Tax Sales Proceeds amount in a given year.

The Internal Rate of Return is a trial-error calculation which finds the sum of: +   The Net Present Value of Year1 The Net Present Value of Year2 The Net Present Value of Year n...                Initial Investment Different discount rates need to be tried until the total of the net present values of all years equals the initial investment. Example: Initial Investment  : $75,000 Year 1 Cash Flow  : $700 Year 2 Cash Flow :  $900 Year 3 Cash Flow :  $1,150 Year 4 Cash Flow :  $1,375 Year 5 Cash Flow :  $1,500 Year 5 Sale Proceeds Cash Flow :  $125,000 STEP 1: Internal Rate of Return Internal Rate of Return (IRR) = 11.94% STEP 2: Year 1 Net Present Value $700 Year 1 NPV=  ------------- 1 (1 + 11.94%) Year 1 NPV= $625.32 STEP 3: Year 2 Net Present Value $900 Year 2 NPV=  ------------- 2 (1 + 11.94%) Year 2 NPV= $718.20 STEP 4: Year 3 Net Present Value $1,150 Year 3 NPV=  ------------- 3 (1 + 11.94%) Year 3 NPV= $819.79 STEP 5: Year 4 Net Present Value $1,375 Year 4 NPV=  ------------- 4 (1 + 11.94%) Year 4 NPV= $875.61 STEP 6: Year 5 Net Present Value Year 5 Cash Flow= Rental + Sale Year 5 Cash Flow= $1,500 + $125,000 Year 5 Cash Flow= $126,500 $126,500 Year 5 NPV=  ------------- 5 (1 + 11.94%) Year 5 NPV= $71,961.11 STEP 7: Add up all the Net Present Values Discounted Cash Flow = Year 1 NPV Year 2 NPV Year 3 NPV Year 4 NPV Year 5 NPV ---------- Total Discounted Cash Flow Discounted Cash Flow = $625.32 $718.20 $819.79 $875.61 $71,961.11 ---------- $75,000 STEP 8: Results As you can see if you use 11.94% to discount the future cash flows the the total discounted cash flows ($75,000) matches or approximates the initial investement ($75,000), that's the measure that tells you 11.94% is this investments Internal Rate of Return.