How To Calculate Internal Rate of Return Without Knowing the Formula

May 21, 2013 By James Kobzeff

Trying to calculate internal rate of return (IRR) manually is not very practical for real estate investors (or anyone else for that matter) because the internal rate of return calculation involves tedious mathematical solutions that take a lot time.

Even the most skilled investment real estate specialist probably wouldn’t know the formula for the return and instead would resort to a real estate calculator, MS Excel spreadsheet, or real estate software program to compute it for them.

So rather than to display the actual formula for IRR (it can be found in other places on the web), let’s instead focus on the concept and show you how to make the calculation without knowing the formula.

Concept

In essence, the internal rate of return is the unique rate that discounts the sum of future cash flows until it equals the initial investment.

• “Initial investment” is the cash investment made by the investor to purchase the income property.
• “Future cash flows” is the cash derived each year the income property is held plus the reversion (the proceeds received upon sale of the property).

Example

Let’s say that you’re an investor looking at a rental income property and would like to know what your IRR would be if you held the property for six years.

You have to initially invest $435,000 cash to make the purchase, are projecting the property to generate annual cash flows of $43,950, $45,504, $47,108, $23,762, $50,468, and anticipate (based upon your projections) to collect $520,000 upon a sale of the property in the sixth year.

• Initial investment: 435,000
• CF1: 43,950
• CF2: 45,504
• CF3: 47,108
• CF4: 23,762
• CF5: 50,468
• CF6: 52,227
• Reversion: 520,000

Okay, now to calculate your internal rate of return you must make your initial cash investment a negative amount (to reflect cash outlay), and combine the sixth years’ cash flow with the reversion (total cash flow anticipated in the sixth year).

• CF0: -435,000 (initial cash outlay)
• CF1: 43,950
• CF2: 45,504
• CF3: 47,108
• CF4: 23,762
• CF5: 50,468
• CF6: 572,227 (total cash flow in sixth year)

Excel

With Excel, you would enter the amounts as shown in the schema above and then use Excel’s IRR function. The illustration below shows the result.

Real Estate Calculator

Using a real estate calculator similar to ProAPOD’s iCalculator provides the same result but makes the calculation somewhat easier. Primarily because it automatically converts the initial cash investment to a negative amount and combines the cash proceeds resulting from a sale with the cash flow collected in the final year (in this case, the sixth year).

Real Estate Software

To avoid making the IRR calculation manually, you can use a real estate software solution like ProAPOD Real Estate Investment Software to make it for you automatically. In this case, you simply fill in the forms with the property’s financial data and preview the result in a report like the proforma income statement.

Rule of Thumb

The internal rate of return is only one of many approaches used in real estate investing. But it is one commonly used by real estate investors to make real estate investment decisions. It accounts for the time value of money and thereby considers both the timing and the scale of anticipated future cash flows.

So You Know

iCalculator makes dozens of real estate calculations with the formulas. You can try it risk-free and save 50% (you pay just $24.95). Click here to learn more and get the discount.

source: http://realestateinvestmentsoftwareblog.com