Internal Rate of Return (IRR)

Internal rate of return, or IRR, is an important commercial real estate metric representative of the annual rate of growth expected to be generated by an investment. Expressed as a percentage, IRR is often used to estimate the profitability of potential investments — technically accounting for the percentage rate earned on each dollar invested for each period it is invested. In a discounted cash flow analysis, the internal rate of return is the discount rate that makes an investment’s net present value (NPV) equal to zero and accounts for the time value of money. Internal rate of return (IRR) helps investors estimate their profitability. Commercial property investors use IRR calculations to analyze and compare different potential investments to determine which is the most profitable opportunity. The entire purpose of IRR calculations is to identify the discount rate — which is the value at which the present value (PV) of the combined annual cash inflows is equal to the initial net cash investment. IRR can easily be compared to the compound annual growth rate (CAGR), except that CAGR calculations only utilize the beginning and ending values of an investment, while IRR encompasses different cash flows across different time periods. Calculating IRR The internal rate of return is calculated in an iterative process using a standard formula. The calculation requires that a few metrics must first be determined. The formula requires an investor to have the net cash inflow, as well as the total initial investment cost metrics on hand along with a given time period — typically a year. Once these metrics have been determined, the IRR can be calculated by setting the NPV’s value to zero in the formula below. Use of a spreadsheet or other software is recommended.