Aligned Ventures
12/08/2022
As a passive real estate investor, there are certain metrics that should mean more to you than others. Obviously, the goal of any investment is to make money. However, part of making money in the world of real estate investing is found in doing your due diligence regarding the property’s numbers before you put your money in.
When you make the decision to be a passive real estate investor, you’re making the decision to put your money to work for you. Many passive real estate investors choose this path because they are actively engaged in earning a regular income from their job. With that in mind, passive real estate is a great way to set yourself up for retirement while increasing your net worth in the present.
There are plenty of metrics out there, but it could be argued that IRR is the most important one for passive real estate investors to know about. Discover more about what this metric is and why it matters for you.
What is IRR?
IRR stands for “internal rate of return.” When dealing with any type of investment, the rate of return is one of your most important metrics. Knowing the IRR of a property allows you to analyze and compare the return that you can expect on your money as time progresses.
There are two primary factors that drive IRR. The first concept involves the theory of opportunity cost of capital. A property’s internal rate of return assumes that there is an opportunity cost associated with making one investment instead of another. The second factor involved in IRR involves inflation. Determining a property’s IRR involves the assumption that a dollar is worth more today than it will be worth in the future because of inflation. Under the basic IRR formula, the further into the future earnings are projected, the lower they become because the dollar is expected to be worth less in a few years than it is worth now.
To calculate the IRR of a property, you must consider the annual cashflow generated by the property. This figure includes any rental fees associated with the property and the eventual sale of a property.
The entire basis of finding a property’s IRR is based on forecasting, which is one of the most important aspects of successful real estate investing. When you’re trying to choose between multiple investment properties, or you’re looking at a single property and want to know if it’s worth putting your money into, knowing the IRR is paramount.
Without going into a long mathematical formula, determining the IRR on a property uses the same formula as the Net Present Value (NPV) of a property. However, when calculating the IRR on an investment property, the NPV is set to zero.
Why You Need to Know IRR
Now that you have a better understanding of what IRR means, it’s important to understand why it is an important number to know. Every property has an IRR. Obviously, you could sit down and calculate the IRR for any property by considering the amount of money that you would be putting in compared to the amount of money that you could expect to make.
One of the biggest benefits of knowing a property’s IRR is found in the fact that it allows you to make an informed decision when choosing between two or more properties. In most cases, a higher IRR makes a property a better investment. While there are a few cases where that may not be the case, it is generally accepted that investors prefer properties with higher IRRs when making an investment choice.
If you are considering two properties for passive investment and one of them provides an IRR of 14% while the second property provides an IRR of 22%, most investors would say that you should choose the property with a 22% IRR.
When to Use IRR
Now that you know what IRR is and the benefits of using it, it’s important to understand when to rely on this piece of information. Obviously, as we’ve already discussed, you should use it when trying to choose between two potential investment properties that you plan on investing in passively.
It’s also a good idea to use IRR only when there is an exit strategy associated with a property. Some investors purchase an investment property with intentions of hanging onto it forever. For instance, if you purchase an apartment complex in a booming college town, you may be able to take a passive approach by hiring a property management company to handle things for you. If that is the type of property that you’re interested in, there isn’t a pressing need to “cash out” and sell the property unless you simply want to do so.
Many types of passive investing, such as real estate syndications, have plans in place that include owning the property for a predetermined period of time before selling the property for a profit. In virtually every IRR formula, the eventual sale of a property is included in the annual cashflow projections. For instance, if the plan is to own a rental property for five years, the first four years’ worth of projections include the rental fees generated by the property. The fifth year involves the sale of the property and its proportion to the initial investment.
As an investor, it’s important that you gather as much information as possible about any property that you are considering adding to your portfolio. While there is no way to determine a property’s exact IRR, determining an estimated internal rate of return is crucial, especially when considering more than one property. The world of real estate investing is all about the details, and the IRR of any property is one of the most important details.
To learn more about how passive real estate syndication investing can work for you click the link below and schedule a call with one of our team members to discuss any additional questions you may have and if were the right fit for you.
