The Internal Rate of Return (IRR) is a measurement of a property’s long-term profitability potential. The Internal Rate of Return considers the annual net cash flow and changes in equity over time.
The Internal Rate of Return is the best indicator of a property’s estimated performance over the lifetime of the investment. The higher an IRR, the better the investment.
Internal Rate of Return is the rate of return each dollar in an investment earns while it is in the investment. IRR is another term for interest rate, discount rate, or yield. The IRR gives investors the means to compare alternative investments based on their return.
Internal Rate of Return isolates the return on a portion of the total amount of money received from the investment over the holding period. For a positive return on investment, dollars received must exceed dollars put into the investment. This return on rate depends on both the amount of the excess and when the excess is received.
Internal Rate of Return is, as its name implies, an internal rate of return because it only measures the dollars in the investment for the time they are in the investment. Therefore, it does not take into account any external factors that affect the dollars taken out of the investment.
Differences between Cap Rate and IRR
Capitalization rates (Cap Rate) and Internal Rates of Return (IRR) are both tools that can be used to measure the return of an investment. Capitalization Rate expresses the income from an investment relative to its price, usually by looking at a single period of income. Whereas the Internal Rate of Return attempt to express what you will make on investment over its entire life, taking into account changes in income, gains or losses on your sale, and the impact of any debt you use as a part of the purchase.
To help you as a commercial real investor to compute the Internal Rate of Return for an investment property, below is a basic IRR calculator.