Essential Insights on IRR: Meaning and Calculation  for investments

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What is an IRR

Internal rate of return (IRR) is the return on an investment which takes into account the cash flows and time scale. An investment with an IRR of 10% produces an annual rate of return of 10% over its lifetime. IRR is the discount rate that makes the net present value of the investment =0. 

How to calculate IRR

• Project all the cash flows over for each year over your planned holding period. This includes both cash outflows and inflows. 

Formula of IRR:

• 0=CF1/(1+Irr)^1 + CF2/(1+Irr)^2+ CF3/(1+Irr)^3+......+CFn/(1+Irr)^n - CF0
• Where Cast flow in year 1=CF1; and cash flow in year n = CFn and so on and CF0 = cash outflow in initial year. 

Let us look at 2 scenarios in which you invest $100,000 initially and generate $200,000 over the lifetime of the investment. However, the timing of the cash flows is different for the 2 scenarios. 

Scenario 1

• The return of 200,000 is spread evenly over 10 years with $20,000 for each year.
• In this case, the IRR is 15%

Scenario 2

• The final value of $200,000 is earned in year 10.
• Then the IRR is just 7%.

 Takeaway

As you can see, in both cases, you make a return of $200,000 in a 10-year time frame. However, the timing and magnitude of the cash flows makes a huge difference in the IRR for each scenario. 

Practical applications of IRR

IRR for Real Estate

IRR can be used to evaluate real estate investment returns and compare different investments. If you’re considering leveraging debt for real estate, here’s a complete guide. This is especially important because in real estate cash flows happen throughout the holding period, and it is important to consider the time and also the magnitude of the cash flows. For example, the initial purchase may be in year 1, but renovations, remodeling and other maintenance expenses can keep happening through the years, and the timing and magnitude of these cash flows will influence the returns.  

Personal investments

IRR is used to calculate return on potential investments. You can use IRR to compare different investment opportunities using a common rubric. Also, understanding your liquid net worth can help you decide how much to allocate. Calculating IRR for different investment options will help you figure out where to deploy your money and maximize returns. However, make sure you also manage asset allocation and diversification in order to manage portfolio risk. One strategy you can explore is The Boglehead Investment Approach.

Pros of IRR

IRR takes into account the time value of money and the timing of cash flows

The IRR is very useful and accurate because it takes into account the timing of cash flows. It understands that $10,000 in 1 year vs $10,000 in 3 years will lead to different rates of return due to the time value of money.

Useful for comparing different investment options

• IRR is great for comparing different investments. For example, you could compare multiple real estate investments by factoring in their cash flows over different periods. 
• For example, even if rental income and appreciation is similar for 2 comparable properties, one investment may require more upfront remodeling and renovation, whereas another investment may require the renovation a few years down the line. This causes IRR to be different, despite similar rental income and appreciation.

Cons of IRR

Hard to calculate manually

IRR is a complex formula and hard to calculate manually. You have to basically plug in various rates of IRR through a process of trial and error until you make the NPV = 0. Alternatively you can use Excel to do this calculation. 

Does not account for size or scale, leading you to make small investments

A smaller scale project with near term cash inflows will have a higher IRR than a longer term project with cash inflows that come in a bit later. However you may make more money in dollar terms with the longer term project.

Relying solely on the IRR calculation will lead you to invest in the smaller project even if you are likely to have higher dollar returns in the larger project.

IRR does not consider risk

IRR does not account for risk to compare different investments. It only looks at expected rates of return.

How does IRR differ from ROI?

The return on investment is the profitability of an investment as a percentage of the  cost of the investment.

It is calculated as follows;

• ROI = (Net Profit/ Investment Cost) * 100

Example:

• Initial investment is $100,000
• Final value of the investment = $200,000
• Return on investment (ROI) = (200,000-100,000)/100000 = 100%

Compounded Annual Growth Rate (CAGR)

When you annualize the ROI per year instead of the entire period, we use a metric called CAGR or annualized ROI.

This is computed as follows: 

• CAGR = (Final value/ Initial value)^(1/n) -1
• Where n= number of years.
• So in the above example, the annualized ROI = 7.18%

Younger investors especially can benefit from compounding; see 8 Financial Planning Tips for Young Adults.

NPV vs IRR

Net present value is the value of all cash flows in today’s terms. 

IRR is the discount rate that makes the NPV equal 0. Therefore, IRR is the rate at which present value of all inflows and present value of all outflows are equal.

Conclusion 

The Internal Rate of Return (IRR) helps compare different investments by accounting for the time value of money and cash flows. It can be applied to evaluate real estate or other types of investments. The IRR is the discount rate that makes the net present value (NPV) of all cash flows equal to 0 over the lifetime of the investment or project. The IRR is, however, hard to calculate manually and requires trial and error to compute. It also can lead one to invest in opportunities that generate cash flow in near terms, even if there is the potential to generate higher returns on projects with a longer time horizon. 

At Planwell, we are building a fully automated AI financial planner and advisor that will allow you to evaluate real estate and other investments as part of our financial planning functionality to help you make super personalized financial decisions such as real estate investing, home affordability, financial independence and kids’ college. 

We will be launching the product in the coming months. Stay tuned for an update. In the meantime, check out our blog posts to help you plan your finances.

• House Hacking: The complete guide to house hacking. 
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• How to Use AI Budget Calculators and Tools to Plan Your Finances: Take advantage of our free FIRE calculator  to plan your finances more effectively.
• Backdoor Roth IRA Process: Learn more about the backdoor Roth IRA process. 
• 5 Overlooked Workplace Benefits: Lesser known workplace benefits that can be super useful and help save a lot of money. 
• How to build a personal financial plan: Build your personalized financial plan with our 10 step guide.