Sunday, September 2, 2012

The Scoop About Internal Rate of Return in Layman's Terms

Probably the most favored investment real estate returns for performing a rental property cash flow and profitability analysis might be the internal rate of return (also known as IRR). This is due to the fact that internal rate of return considers for time value of money. That is to say, IRR makes it possible for the real estate investor to take into account both the timing as well as the degree of cash flows provided by the rental income investment property.

Yes, that is a mouthful, however bear with me. In this short article I genuinely will attempt to explain exactly what internal rate of return is in layman's terms so others like us are much more likely to wrap our hands around.

Here's the idea.

IRR concerns the yield the real estate investor can expect to see on the investment capital he or she invested to buy an ivestment property based upon the anticipated sum total of future income streams. Namely: the sum total of future income divided by initial investment equals rate of return.

However in this case, instead of simply dividing the amount of those future income streams by the total amount of investment, IRR applies a "discount rate" to the future revenue in an effort to compute the "present value" of those streams before dividing by the invested funds. This is the concept known as "time value of money".

Let's consider a simple example that may demonstrate it.

Say that you happened to be offered the choice to either receive ,000 right now or instead to put it off and get the money one year from today. Which opportunity would you choose? Naturally, you would accept the ,000 now because you know full well that inflation erodes purchasing power over time and that ,000 just isn't going to buy you an equal amount of goods one year from today as that exact same amount will at this very moment.

That is the very same assumption internal rate of return is concerned with. That is that a dollar gotten tomorrow is worth less than one gotten today. As a result, it considers the "present value" of those forecasted future cash flow streams in order to better align the value of that income with the monetary value of the investment being made today to purchase the investment real estate.

To show you just how important internal rate of return might be to a real estate investor's evaluation of a property and subsequent investment decision, we'll consider the following illustration.

Let's consider that 0,000 is paid out in order to buy a commercial building. During the course of one year it produces a cash flow of ,000, and at the end of that same year can be resold for a gain of ,000. That is, the property generates a future income that totals ,000.

1) The rate of return (without accounting for time value) is mathematically computed just by dividing the ,000 by 0,000 or in this instance 25.0%.

2) IRR on the other hand does account for time value. Therefore it would first off discount future income before doing the math. If we assume a 10% discount rate, then the present value of the future income becomes ,727, which when divided by the investment equals 22.73%.

You can see the problem. A real estate investor that ignores the time value of money might wrongly purchase a rental property based on getting a 25% return when all the while the internal rate of return method reveals a noticeably lower return that is most certainly one closer to fact.

It is highly recommended for those of you engaged in real estate investing that you make the investment and buy a good real estate investment analysis software solution that can calculate IRR for you before making a decision on your next investment opportunity.

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