Real estate and investment calculations can look terrifying if you’re not a professional investor, stockbroker or accountant — and sometimes, they can be off-putting even if you are.
We’re here to help clear up one mathematical aspect of real estate investments that can be a powerful tool in helping you decide where to invest your money — a potential investment’s internal rate of return, a figure you’ll typically see abbreviated as its IRR.
A project’s internal rate of return is a projected rate of growth it is expected to return within a set amount of time, which you — the potential investor — work into a formula (don’t panic — we’ll explain it.)
A project’s IRR can be a fairly solid way of predicting whether it will be a good investment. However, we’ll caution you against looking at mathematical projection as a crystal ball — an IRR is very rarely perfectly precise.
Since it’s calculated using the same formula used to calculate an investment’s net present value, an IRR can easily be compared against a different project’s current value, or against specific existing securities, giving investors more information about how a potential investment will stack up against current “known commodities.”
How it’s calculated
OK, this part contains a little math. Bear with us.
- The formula to calculate an IRR is the exact same one used to calculate a net present value — an NPV.
- That formula uses initial investment, net cash inflow and interest rates to calculate the amount of money an investment needs to make to give you a certain amount.
- You can look at it as the percentage rate earned on each dollar invested for each period it is invested — the percentage of each dollar you make, for each year you invest it, for example.
- In real estate holdings, that means the percentage on each dollar of your original investment, for every year until you sell the property, or your share.
- You can see how that would be a handy figure to have in your back pocket as you navigate potential investments.
IRR is not a crystal ball
- We want to reiterate: a project’s internal rate of return is no guarantee of how it will perform in the “real world.”
- It’s not a guarantee of annual compound rate of return on an initial investment.
- An IRR figure is also not calculated with the inherent assumption that interim cash flows are reinvested in the project, which isn’t always the case — that can change the end result.
- We are happy to help you decide which fund is best for you. Reach out to RE/DEV and let us give you a hand.