There is more than one way to analyze the returns of a real estate investment. Internal rate of return, or IRR, is one commonly used method, but it isn't the only way to calculate your return on investment, or ROI.
In a nutshell, IRR is a specific calculation method for investment returns, while ROI is a broader term that refers to all of the various methods of calculating investment returns. With that in mind, here's a rundown of what IRR is and the various other ways you can calculate ROI on a real estate investment.
What is IRR?
Internal rate of return is a way to calculate an investment's returns over a set period of time -- typically on an annual basis. And it is used as a forward-looking metric, typically to analyze investment returns over a certain future time period.
IRR is a mathematically complex calculation, taking into account the cash outflow (acquisition cost) of the investment, the current discount rate, and net cash inflow for each year throughout the investment period to determine the net present value of an investment's gains relative to its costs. While there is an IRR formula, in practice, IRR is rarely calculated manually. Financial calculators and spreadsheets can quickly and easily perform the IRR calculation for an investment.
IRR can be especially useful if an investment has inconsistent cash flows or there's a lump sum gain from the sale after a certain amount of time. For example, let's say you buy an investment property for $400,000, earn no cash flow during the first year, generate cash flow of $30,000 per year for the next three years, and then sell the property at a $40,000 net profit. IRR can help you assess the entire return on an investment in one annualized metric.
In most situations, one of the simpler ROI metrics discussed in the next section is an easier way to calculate an investment's returns. However, IRR can be a good way to compare investments with different cash flow structures and holding periods to determine the best place to invest your money.
What is ROI?
ROI, or return on investment, is a more general term that refers to a variety of methods investors could use to calculate the performance on their investments. Internal rate of return, or IRR, is one method of calculating potential ROI.
Recall that IRR is a forward-looking metric, meaning that it is used to analyze an investment's potential returns over some future time period. Other methods of calculating ROI, like those I'm about to mention, can be used either to analyze an investment's potential returns in the future or can be used to analyze an investment's actual returns over some historical period.
With that in mind, when it comes to investing in real estate, some other popular ROI calculation metrics that investors can use include:
Capitalization (cap) rate
A property's capitalization rate, or cap rate, refers to its net income as a percentage of its market value. For example, a rental property that is worth $200,000 and generates $16,000 in net income for its owners would have a cap rate of 8%. Typically, cap rate is used by investors when deciding how much to pay for a property or determining what a fair selling price would be. In these situations, instead of using fair market value, you would use the property's acquisition or selling price to calculate cap rate.
Cap rate can be a useful ROI metric to determine how much you should buy and sell real estate for, but unless you are paying cash for a property, it doesn't give you a good idea of how much your out-of-pocket investment returned for you.
Cash-on-cash return tells you your investment profits expressed as a percentage of the money you actually spent. For example, if your down payment and other acquisition costs on a property add up to $30,000 and you make $3,000 in annual net cash flow after expenses, your cash-on-cash return is 10%. Cash-on-cash return can be used just to analyze cash flow returns, or it can incorporate a lump sum from the profitable sale of an investment.
Think of total return as a simplified version of IRR. Total return is a combination of income and equity appreciation of a property. For example, let's say you buy a property for $100,000 cash and earn $5,000 in net income during your first year of ownership. In addition, after one year, the property has increased in value to $103,000. Combining your 5% cash-on-cash return and the 3% equity appreciation gives you a total return of 8%.
Annualized total return
Like IRR, total return is best used as a long-term ROI metric, with the big difference that total return can either be rear- or forward-looking. And it's best expressed on an annualized return basis if it's used for periods greater than one year.
For example, let's say you spend $50,000 out of pocket to acquire an investment property. Over a three-year holding period, you earn a total of $10,000 in net income, and at the end of the three years, you sell the property for a net profit of $20,000. This adds up to a 60% total return over three years, which can be annualized by using this formula: