A real estate asset’s internal rate of return (IRR) sounds simple enough to comprehend for those taking it at face value, but this metric is often misunderstood. Typically, investors will use an IRR calculator to determine the potential profitability of a future investment, but it’s capable of so much more.
When taken into proper consideration, and with a mind for due diligence, the IRR can help investors choose between assets that are dissimilar. In other words, a good internal rate of return calculator can compare “apples to oranges” when investors are choosing between two unique investment opportunities. Continue reading to learn more about the internal rate of return metric, and how you can potentially use it to your advantage with your investments.
The internal rate of return is a metric used to determine the percentage rate earned on every dollar invested into a respective asset. Investors often use an IRR calculator to determine the profitability of a potential investment, and gauge whether or not to proceed with a deal.
Perhaps even more specifically, the IRR functions as a scale––one that allows investors to weigh the potential yield of one investment against another. An asset’s IRR may be used to compare its projected rate of growth to different investments of varying types. The IRR is, therefore, most useful to investors when they need to compare unique investment opportunities. More often than not, the deal with the larger IRR will win out, as it coincides with more potential.
That said, there are caveats in the internal rate of return metric that must be accounted for, not the least of which will be discussed later. For now, it’s important to know that the internal rate of return should never be used alone; it should be used in conjunction with one more important metric: the net present value (NPV).
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While they share some similarities, there are very important differences to account for between IRR and net present value. Each of these metrics are used primarily to evaluate capital expenditures; however, that’s where there similarities end. Whereas the IRR is intended to calculate a percentage rate of return on a given asset (a return that will result in a net present value of zero), the NPV discounts an asset’s expected cash flow, which will often identify a surpluses or loss.
Let’s take a closer look at some of the more notable differences between IRR and NPV:
The internal rate of return is a great way to forecast a project’s rate of return, but it’s just that: a forecast. The Internal rate of return is by no means guaranteed, nor should investors ever assume it is; it is nearly a projection of what an investor may be able to expect. As such, the IRR can be misleading if used incorrectly. More importantly, there are several advantages and disadvantage one needs to consider by implementing this equation themselves:
The internal rate of return is a metric best utilized by those looking to compare two unique assets. Expressed as a percentage rate, the IRR can help determine the rate of return between two dissimilar projects overtime, and help investors choose which might suit their needs the best. Keep in mind the caveats associated with the internal rate of return, and be sure to utilize it amongst other calculations, including the net present value (NPV). Investors with a good understanding of the IRR can use it to their advantage and profit.