The Internal Rate of Return is one of the most common indicators for understanding and comparing your returns for real estate investments.
IRR is best explained with an example.
First an explanation of Equity Multiple (EM) and average annual Return on Investment (ROI), which are important concepts in their own right, and vital in terms of understanding IRR.
Consider a situation where you invest $1000. After five years you have received a total of $2000 back - $1000 in addition to getting your initial $1000 back.
The equity multiple is a simple calculation of what you get back compared to what you put in. If you receive a total of $2000 back, after putting in $1000, then your Equity Multiple is 2. You received back twice what you put in.
Your Return on Investment (ROI) is similar, though only takes into account the additional money you made. In the example above, your total ROI is 100% as you made $1000 over and above the $1000 you initially put in.
If we want to express this as an annual average, then we need to divide the total ROI by the number of years. Considering that it took 5 years to get your returns, your average annual ROI is 20%.
In the above example, WHEN we are paid our money could be important to deciding between two investments. Let's look at two scenarios from our example above.
1. In the first scenario, you receive your $1000 back in the very first year as well as your first $200, and then $200 a year for the next four years. After five years you have received a total of $2000. Your average annual ROI is 20%.
2. In the second scenario you receive $200 a year over five years, and get the $1000 in the last year. Again, after five years you have received a total of $2000, and your average annual ROI is still 20%.
Though are these two options both equal in terms of your preference as an investor?
In the first year your receive $1200 in scenario 1, while only $200 in scenario 2. For scenario 1 this is great news – firstly the deal now has less risk, as you already have your $1000 back fairly quickly. Secondly you can now use that money again for the next four years to earn more money through other investments or interest.
Scenario 1 is clearly a better option.
The problem with annual average ROI is that it does not take into account WHEN your returns are paid to you. IRR attempts to solve this.
Using the examples above, we can see how IRR can be of value.
The IRR of scenario 1 is 51%, significantly better than the IRR of 20% for scenario 2.
* The definition of IRR requires a complex calculation which we have not included here. For a full description of the IRR equation click here.