Real estate investors commonly use the internal rate of return (IRR) to evaluate the likely profitability of a current or future project. One reason it’s popular is simply that there are few comparable metrics available in real estate. Unlike with stocks and bonds, there’s certainly no direct, straightforward way in real estate to rate performance.
As is implied in the term, IRR is a way to calculate a project’s rate of return. But what is a good IRR? Here’s that and more.
What is the Internal Rate of Return?
Expressed as a percentage, IRR is a tool that investors use to assess what they will likely earn from an investment, on average, over time. The calculation does exclude external factors such as financial risk, inflation, the risk-free rate, and the cost of capital.
What are Defining Elements of IRR?
Two of the most important terms in IRR are “profit” and “time.” The first one is easiest: profits are earnings that total more than the amount initially invested, fewer investment expenditures such as property taxes, and ongoing maintenance.
“Time,” though, is a bit more complex as it relates to the internal rate of return. This is large because market forces like inflation can cloud IRR results. After all, $100 today isn’t worth what was 20 years ago, and it won’t be worth the same 20 years from now. So, because the value of money changes over time, so will profit.
Why is IRR Popular Given its Complexity?
Well, the formula is complicated, but the calculation isn’t. That is, if you use an IRR calculator, as most investors do.
Also, because the internal rate of return considers the time value of money, and all future cash flows are added to the calculation, each cash flow is weighted the same. That helps when considering money’s value from a time perspective.
The tool, which can be used with others, by the way, helps you to compare projects or potential projects in terms of likely profitability. This helps with setting priorities.
Are There Any Downsides to IRR?
There is no perfect tool. Having said that, it’s true that IRR is unable to deliver a complete look into the future. That’s because the IRR equation doesn’t consider the cost of capital.
The metric also doesn’t consider a project’s size or potential costs that could affect future costs. Such costs can include fuel and ongoing maintenance.
Another possible IRR demerit is that it doesn’t consider reinvestment rates. After all, it’s not always practical to assume that the value of future cash flows can be reinvested at the same rate as the internal rate of return.
What is a Good IRR?
In general, the higher the IRR, the better. But there are some nuances about which you should be aware. Beyond the result you get, a “good” IRR is simply one that you believe represents a large enough return on your investment, accounting for risk.
What constitutes a good IRR also depends on what you want to do. For example, if you’re looking to develop in an established area, a favorable IRR would be 20 percent – 35 percent in an unproven area. If you’re looking at the acquisition and repositioning of an asset that’s floundering, you’ll want a 15% IRR. But if you’re seeking to acquire a stabilized asset, an IRR of 10 percent is about ideal.
And remember, IRR is not entirely revelatory in that it doesn’t consider an investment’s length or level of risk. That’s why the IRR should always be considered along with factors such as calculated and assumed cap rates, the NPV, and the number of times you can get your cash investment returned.
In sum, what is a good IRR? That’s ultimately a subjective determination based on your perception of risk. But at least you now have some perspective. If you wish to learn more about IRR, the alternative platform Yieldstreet has some resources that can help.