What is IRR for Real Estate Investors
By Sean Wheller
This question of what is IRR Internal Rate of Return is one of the most frequently asked questions and often even when explained property investors that do not have a financial background, do not fully understand this concept. In this article we are explaining in the simplest way possible what is IRR or Internal Rate of Return.
As we are all aware, property investment decisions are highly based on the assessment of the cash flows which can be generated by the property. Examples of these cash flows are rentals, levies, maintenance fees, taxes and other cash flows which are received, or paid as a direct result of ownership of the property or the carrying on of a rental business.
In determining how much a property is yielding, an investor determines the NET cash returns in future and compares them with the initial capital invested. This is a simple principle and can be explained as such: If you have 100,000 invested in the bank and you earn interest equaling 15,000; it is obvious that the investment has returned a gross of 15% (as 15,000 represents 15% of 100,000). The principle is the same in property, except that this time, your investment is the amount that you paid for the property and the receipts are NET cash flows.
The NET Cash flows received from the property represents a percentage of the amount initially invested. This is the effective return that you are receiving on the property; i.e. your INTERNAL RATE OF RETURN. I say effective return because it is the percentage you have effectively enriched yourself by, through renting out this property; and this is why we use NET cash flows.
Determining Net Cash Flows:
The NET Cash Flow of the property is easily calculated. The NET Cash flow is the cash inflows, minus the cash outflows each year. Most often, these cash flows can be determined over the time that the investor intends to hold the property.
Let's go back to the above investment again: Suppose you make that 15,000 and pay tax of 5,000 as well as bank charges throughout the year of 500. The net of the cash inflows (15,000) and the cash outflows (5,000+500), will give you the NET cash flows generated by the investment. This NET cash flow is 9,500. Now to find out the return you take the net cash flow of 9,500 and you divide this by the investment which in our case was 100,000. We can now see that the effective rate of return is not 15%, but rather 9.5%; as represented by the net cash flows.
You can easily estimate the amount of rentals you will get and the amount of levies you will pay every year because they are usually fixed or increase with a fixed rate. Other costs, that cannot be easily estimated, are usually estimated on the basis of past experience; such as how much you spent the year before on the maintenance of the property, or by assessing the state of the property at the beginning of every year.
IRR - Internal rate of return:
The real challenge is really to estimate the net cash flows that your property will bring you over time. The estimation does not have to be perfect, just appropriate and realistic; this will allow you to make good investment decisions.
The calculation of internal rate of return requires a financial calculator. The calculator basically discounts all the net cash flows in future to an amount today and compares that amount with the initial investment in order to get the % return.
Why is IRR Important?
In past articles, I spoke about the "Cost of Capital" principle. This is the cost associated with the funds that you invest and is made up of factors such as interest and most importantly risk.
When one makes an assessment of the IRR and calculates it, one must make sure that the IRR is higher than the cost of capital; otherwise, your investment is not giving you any REAL profits. Take the same example as before: we calculated that the IRR was 9.5% per year. If the investor took out a loan for that money that is costing him 16% per year, of which 5% percent is a tax deduction; he has an effective cost of 11% per year which he incurs, to earn, 9.5% per year; giving him an effective loss of- 1.5% per year.
That is where the beauty of property comes in. Because of capital appreciation, when you sell your property in future, those cash flows make up for any effective losses you have made while holding the property.
That said, you must make sure that you are able to sustain any monthly shortfalls that the property may carry until the date of sale, otherwise you can lose the property to the bank before you realize any REAL profits.
Please note that this is not financial advice in any form. The data in this article is informational only for real estate investors to illustrate tax issues. If you need financial advice refer to a professional that can assist you with your particular circumstances.
About the author
Sean Wheller is a real estate agent, investor and the founder of the largest online property investing education website in South Africa that specializes in real estate training, and real estate investing courses and seminars. from http://www.FreeArticlesAndContent.com
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