Internal Rate of Return: Calculating Annual Expected Return

In this Drinks and Deep Dives show, Chelsea Scott joined me to talk about Internal Rate of Return (IRR).  This is a powerful but complex metric for calculating annual expected return.  It’s a dynamic way to measure returns because it considers the time value of money (a dollar tomorrow is worth less than a dollar today) and takes into account all cashflow: initial negative cash outlay (down payment), annual cashflows, and proceeds from the sale. 

We can even use this metric to determine how much of a return is generated from cashflow vs appreciation.  Using this information, we can decide whether it’s better to buy a property in a cashflow or appreciation market, depending on an investor’s needs and goals.  IRR is too complicated to calculate by hand and requires a spreadsheet or software to complete.  While it’s one of our favorite metrics, we don’t often discuss it due to its complexity.  We’re going to cover it more in future episodes, so stay tuned!

The IRR, or the internal rate of return is a useful measure when evaluating the performance of an investment with multiple payouts over a period of time.  When using the IRR to evaluate a real estate investment, the calculation will account for varied cash flows, capital improvement expenses, refinancing and the sale of the property over time, factoring in the time-value of the investment.

In this podcast we take a look at holding a condominium purchased for $200,000 with $50,000 down.  In one scenario we start with the amount of money borrowed, which is $150,000 and the rate of return on money that the investor borrowed.  In this case, the IRR ended up at over 10%, using a 3% appreciation rate year-over-year and a 4% interest rate on the loan.  So, that means you are making money on borrowed funds.

In the second scenario, we do the same for the downpayment of $50,000.  When looking at the money you contributed to the investment, this IRR is 24.71%.  An incredible return!

After evaluating the IRR of this investment, we then partitioned out the IRR using the above cash flows, the initial investment of $50,000, a 3% annual appreciation rate and a 4% interest rate to determine that the amount of cash flow and appreciation being returned to the investor over a 10 year period, is almost 54.5%/45.5%, respectively.  Since this is an actual condo purchased here in Denver, it shows that this particular investment property is located in a market with almost as much cash flow coming back to the investor as appreciation of the property.

YouTube Video: Internal Rate of Return: Calculating Annual Expected Returns