IRR stands for Internal Rate of Return, which is a metric used to analyze capital budgeting projects and evaluate real estate over time. It is a tool used by real estate investors to better understand an investment’s realized or potential profitability as it relates to time in a variety of ways. IRR is particularly important for real estate investors because it provides an “apples-to-apples” comparison of two cash flows with different distribution timing. It is calculated using the same concept as net present value (NPV) and represents the percentage rate earned on each dollar invested for each period it is invested.
In real estate, IRR gives the investor a baseline to establish how much the current investment will return over a period of time. It is used to evaluate profitability and to determine the investment return of various assets. For example, if the IRR is higher, it can be determined that the investment is more likely to be profitable for the investor.
IRR is calculated using a formula that takes into account the net cash inflow during the period, total initial investment costs, the number of time periods, and the internal rate of return. While IRR is an important tool for companies in determining where to invest their capital, it does have limitations. For example, it does not factor in the risk of an investment, which is extremely important to most commercial real estate investors.
