Why Internal Rate of Return (IRR) is important?

In commercial real estate, it’s smart to think ahead and keep a close eye on the numbers.

As a commercial broker with more than two decades in the ring, I’ve continued to rely on a variety of metrics, including Internal Rate of Return, or IRR, to ensure my investments are sound.

IRR stands strong in its ability to identify the value of an investment over time. In essence, it quantifies the yield you’ll achieve after you invest in a property after an approximate ten year period — a metric used based on the average holding period of about seven to ten years.

The calculation accounts for the income generated by the property with expenses, or the Net Operating Income (NOI), and assumes you’ll sell the property based on future income on the tenth year.

calculating IRR

To calculate the IRR, you’ll need to identify expected cash flows for each year, accounting for outflows in the first year. To calculate cash flows, or the Effective Gross Income (EGI), you must subtract potential gross income from vacancy rates and identify your NOI.

Once you’ve identified assumed income achieved for each year, you should be able to see a steady growth. Ultimately, you should achieve an approximate 1 to 5 percent assumed growth rate per year.

Now that you have calculated the expected NOI through year 10, you are in the green to select a capitalization rate, or a cap rate, which is the ratio between NOI and the property’s asset value. You’ll want to make the selection for year 11, when you plan to sell the property.

Often, I’ll set the cap rate to about .5 percent higher than the rate in which I purchased the property — so if I purchased the property at a cap rate of 6, I’ll use a 6.5 rate in year 10 and cap the year 11 income to produce reversionary value.

IRR spreadsheet

Software programs like Excel do wonders in making IRR calculations a cinch. Often, IRR’s sit around 15 percent, however they can get higher if you’re refinancing a property or are involved in a development.

So, if you’re an investor looking to gauge the profitability of a future commercial real estate deal, I’d recommend taking a look at IRR.

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