IRR: Internal Rate of Return

What does it all mean?

IRR stands for Internal Rate of Return. Simply put, it's the annualized rate of return that an investor can expect to earn from a project. Companies use IRR to evaluate a project's viability and to compare projects to one another. For example, a manufacturing company may use an IRR calculation to determine if it's better to invest in expanding an existing facility or if it's better to build a new facility. Real estate investors use IRR to compare projects to one another. Generally speaking an IRR >15% is considered attractive to most passive real estate investors.

Real estate investments are often capital-intensive projects that have different returns each year. In a development project, it's common to have significant cash-outlay in years 1 and 2 when the building is being built. Once the structure is built, it's rented to tenants and at that point, investors can expect consistent positive cash flow in the years following its construction.

Apartment buildings, both existing and new construction, are often evaluated using a 5 or 10-year time horizon. If it's a 5-year project, the assumption is that the operator will sell the building in year 5 and investors will earn a significant in-flow of cash. The sale of the property creates a large return in year 5, assuming the property has been properly managed. In this example, an investor who buys into a 5-year apartment building development could expect negative cash flow years 1 and 2, strong positive returns in years 3 and 4, and a massive positive return in year 5.