Building on our article from last week, we’re going to focus this week on a commonly used term in finance called the Internal Rate of Return (IRR).
Before we get into IRR, we first need to give a quick refresher on capitalization (cap) rates.
The formula can be expressed graphically as follows:
I = Income
R = Cap Rate
V = Value
Here’s a quick tip if you’re learning this for the first time. If you set it up exactly as the picture above, you can cover up the variable you’re trying to determine and the position of the two remaining variables will be the formula. For example, if you’re trying to find R, simply cover it up to reveal I over V, or I/V. In other words, divide Income by Value to get the Cap Rate. Or if you want to find V, cover it up to show I/R. This shows how income divided by the Cap Rate will give you Value. Lastly, if you are trying to figure out the Income, cover it up to show R V, or R * V, since they’re side by side. The Cap Rate multiplied by the Value will yield the Income. Once you do the calculations over and over you’ll eventually know if instinctively, but this is a great way to get started.
For example, let’s assume a property is valued at $1,000,000 and has $100,000 in income. Since we’re trying to find the cap rate, cover R and you’ll see it’s calculated as $100,000 / $1,000,000 to equal 0.10, or 10%.
As we mentioned last week, the cap rate formula is the starting point for most real estate analysis, whether it’s a beginning investor or a large institutional investor.
However, by very nature of the calculation, the cap rate formula omits a few important aspects of real estate ownership. We’ll discuss two before getting into IRR. One, it does not take into account any changes in rent, or stated another way, it assumes rent in year one will be the same in year two or year ten. Second, the calculation implicitly assumes that the selling price will be identical to the purchase price. Here is where we introduce IRR, and before we go further don’t be overwhelmed by the terminology, but instead view it simply as the rate of return for a property. In the most basic terms, the IRR will calculate the return based on multiple years of income and account for any changes in the rent or the forecasted selling price.
Let’s go back to the example above, and assume the investor will own the property for 5 years, then sell it for the same price at the end of the holding period.
If you enter the data exactly as we presented above and run the formula =IRR(B2:B7), you’ll see the Internal Rate of Return equals 10%, the exact same as the cap rate.
We hope you’re following us so far, because here is where the potential of IRR starts to develop. Let’s now assume that the income is going to rise over the holding period. Perhaps there were scheduled bumps in the rent, or maybe the building has an upcoming vacancy and the owner will be able to renovate the space and lease it at higher rates. We can also assume that the property will be worth more in five years.
If you use an excel spreadsheet, you can quickly change these numbers and the IRR will automatically recalculate. In fact, you can come up with any number of scenarios to see what effect it will have on the IRR.
The other benefit of IRR analysis is that you can account for financial leverage and tax implications, whereas those considerations are ignored altogether in the cap rate method. Sophisticated Discounted Cash Flow Analysis will incorporate not just financial leverage, but also model all the tax considerations to produce both a before-tax and after-tax IRR.
So it should be clear that we overly simplified this concept and glazed over a number of details for brevity. It’s critical to note the IRR model also incorporates a number of assumptions, so there is an undeniable potential for forecasting error.
As any seasoned investor will testify, a Discounted Cash Flow Analysis is only as useful as the time and effort that went into creating it. We hope this provided a helpful overview on the topic, but we strongly encourage you to keep learning about IRR & NPV if it’s of interest. These techniques can be applied to a myriad of situations, such as comparing investment properties, lease agreements themselves, and even considering whether to buy or lease. It’s a remarkable financial concept that applies naturally to real estate, but the techniques can be applied to virtually any investment where there is varying cash flows.
Chad GriffithsPartner, SIOR, CCIM
Chad is a partner with NAI Commercial Real Estate and focuses on the Greater Edmonton area. Chad entered the industry in 2004 and has completed over 400 commercial transactions with clients ranging from small, local companies to large institutional owners. Chad has been a top 15 producer with NAI Canada-wide since 2013.
Ryan BrownPartner, BCom, SIOR
Ryan is a partner with NAI Commercial Real Estate in Edmonton and is currently ranked nationally as one of NAI's top advisors. Having executed in excess of $100 Million worth of sales transactions and over 2 Million square feet of lease transactions, Ryan has developed a firm understanding of asset evaluation and an aptitude for building design, functionality, and long-term practicality.
Darcie is a licensed Commercial Real Estate Agent in the Province of Alberta with a focus on the Edmonton market and its surrounding areas. Darcie accomplishes custom solutions for her clients through her personable nature and results driven attitude. Darcie can help if you are looking to invest in commercial real estate or are looking for representation for a sale or lease transactions.
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