Internal Rate of Return (IRR) represents the average annual return over the lifetime of an investment. Calculating IRR can seem complex and potentially intimidating to the average investor.
Luckily, modern tools and software make the process simple if you know how to use them. That being said, it’s important to understand the underlying components of the formula since even slight changes in assumptions can greatly impact results. If you’re new to the concept of IRR take a look at Real Estate Defined: Internal Rate of Return (IRR) before diving into the details of how IRR is calculated.
Here’s How to Calculate IRR:
The formula may look intimidating, but it breaks down into fairly straightforward components.
- NPV: NPV (Net Present Value) is the sum of the present values of incoming and outgoing cash flows over a period of time.
- N: The total number of periods in the span of time being evaluated. This often represents the total number of years.
- Cn: Cash flow in the current period at that step in the formula.
- r: Represents IRR. This is the value you’re solving for.
- n: The current period at that step in the formula.
A Real Life Example of IRR
In a scenario where an investment is made up of a single, outgoing cash flow event (for example, the purchase of an apartment building) followed by multiple, incoming cash flow events (i.e. regular rent payments) the expanded formula would look like:
By hand, solving the equation requires trial and error, plugging in various numbers for r until you find a value that makes the equation equal to zero. Fortunately, Excel and Google Sheets provide a simple function for solving the equation assuming you have the other inputs necessary for the formula - cash flow in and out of the investment.
To solve for IRR, enter the series of cash flow events into sequential cells (e.g. A1, A2, A3…) and in the next open cell enter =IRR(A1:A3) where the range inside the parentheses covers the full series of cells representing cash flow events.
While the formula may appear intimidating at first, modern software makes calculating IRR quick and easy. The difficulty is in determining all the numbers that go into the equation. Predicting cash flow requires numerous assumptions about future events relating both to the investment and the surrounding market. The resulting IRR calculation is only as reliable as the assumptions that go into it. For that reason, it’s important for investors to understand the fundamentals of the IRR equation and the importance of making sound assumptions.