In real estate, the internal rate of return (IRR) is a metric used to evaluate the profitability of an investment over its lifetime and is represented as the average annual return percentage. The IRR of an investment can be calculated forward-looking to estimate potential future returns or backward-looking to measure the performance of a completed investment. Technically, the IRR is the is the rate of growth necessary for the value of the asset today to equal its projected value in the future, in other words to have a net present value of zero.
Many sophisticated investors prefer IRR to other traditional metrics by which real estate investments are measured such as Cash-on-Cash or Yield, because the IRR takes into account both the time value of money as well as assumptions about future performance and therefore provides a fuller analysis of the true potential return on investment.
Example Usage of IRR
The internal rate of return would allow a company to more accurately evaluate how different investments would pay off over the next three years. It could also inform an individual’s decision on whether to try an investment alternative or stick with their current strategy.