Internal Rate of Return (IRR) is a commonly used metric in commercial real estate (CRE) investment analysis to measure the profitability of a real estate investment. IRR represents the annualized rate of return for a property investment, taking into account both the initial investment and the expected cash flows from the property over time.
To calculate IRR, you need to know the expected cash flows for each year of the investment, including the initial investment, the expected rental income, and the expected expenses. This information can then be used in a financial model to calculate the IRR using a spreadsheet, which has a built-in IRR function.
Here’s the basic formula for calculating IRR:
The discount rate that makes the present value of the expected cash flows equal to the initial investment
The IRR calculation considers the time value of money, meaning that the value of money received in the future is worth less than the same amount of money received today. The IRR calculation also assumes that the cash flows generated by the property can be reinvested at the IRR rate.
A high IRR indicates a more profitable investment, while a low IRR suggests a less profitable investment. IRR is often used in CRE investment analysis to compare the expected return on different investment opportunities and to determine the optimal investment strategy on a specific property.