Internal Rate of Return and Multifamily Real Estate Development
The internal rate of return is used to measure an investment’s performance based on the percentage rate earned on each dollar invested for each period it is invested.
Setting the Stage for IRR
An internal rate of return, or IRR, calculation sounds more complicated than it is.
This next part is going to sound unrelated, but stay with me.
I used to be a street performer. I played the piano in Stratford-upon-Avon and Birmingham, England (here's my cringe-inducing proof; please don't judge me), for a few years in order to eke out a living while I was going to graduate school.
One thing every street musician needs to think about is: What music should I play? Which songs will bring in the most money?
The answer was…difficult to arrive at sometimes.
When I saw small children, I'd probably lean in to playing something like "Let It Go" from Frozen (remember: We're not judging me).
When I performed outside the Royal Shakespeare Company theater in the evening, I'd usually go for more classical music, with some new age sprinkled in.
Songs are investments. You invest time, money, and significant effort. Not to mention the energy and apologies I needed to invest in placating my upstairs neighbors.
Like any investment, I needed to measure my rate of return to see what was working best — and what kinds of music I should spend more time on going forward.
For pianists and multifamily developers alike, IRR calculations are essential for choosing the best investments to pursue.
Understanding Internal Rate of Return (IRR)
Investment opportunities are only as good as the amount of return they offer, after all. When you’re trying to determine how to calculate the amount you can expect from a real estate venture, such as building a multifamily property, it quite literally pays to know not only what you can expect but when you can expect it.
What Is an Internal Rate of Return?
An internal rate of return (IRR) takes into account the time value of money in accordance with discounted cash flow analysis. Obviously, factors such as inflation can make your dollar today worth far more than it will be in a week, month, or 20 years. When we are talking about commercial real estate, the process is further complicated.
To put it simply, the internal rate of return is used to measure an investment’s performance based on the percentage rate earned on each dollar invested for each period it is invested, according to Property Metrics.
Calculate Your IRR in Seconds
Drop your figures into our calculator below to calculate the internal rate of return of your investment.
Why Is IRR Important?
IRR is crucial for investors to analyze various projects and to compare them with confidence. There are several advantages to using IRR in commercial real estate estimation. Perhaps most importantly, IRR utilizes the time value of money which shows the appropriate value of the investment by discounting the time it will take to accrue. Plus, IRR is easy to calculate and offers a simplistic way to compare projects, and it mitigates the risk of coming up with a divergent rate of return.
How Multifamily Real Estate Developers Benefit from Calculating the IRR
To calculate the IRR of any project, you are essentially taking into consideration the cash flows net of financing to come up with a valuable equity. Complicated? Not really. In fact, you can easily use your Excel software program to calculate the values you’re looking for by simply inputting your numbers. Doing so puts you in a better position to determine the right investment for your project, or the right project to invest in altogether.
To evaluate your multifamily real estate opportunities the right way, and to avoid getting too far in with a project you shouldn’t be involved with, calculate the IRR from the get-go.
Related Questions
What is the internal rate of return for multifamily real estate development?
The internal rate of return (IRR) for multifamily real estate development is a measure of the expected return on an investment. It is calculated by taking into consideration the cash flows net of financing to come up with a valuable equity. To calculate the IRR of any project, you can use your Excel software program to input your numbers. This will help you determine the right investment for your project, or the right project to invest in altogether. Investopedia has more information on calculating the IRR.
What are the benefits of investing in multifamily real estate?
Investing in multifamily real estate can provide a number of benefits, including potential for high investment returns, the ability to take advantage of compounding returns, and the ability to diversify your investment portfolio. Additionally, multifamily properties provide reliable monthly cash flow from renters due to reduced risk of vacancies.
For more information, please see the following sources:
What are the risks associated with multifamily real estate development?
The risks associated with multifamily real estate development include construction costs that have risen dramatically over the past few years, construction delays due to supply chain issues, and the possibility that the renovation work may not be enough to get the desired investment outcome. Additionally, buying multifamily properties is significantly more expensive than buying single-family homes, and buyers should be able to come with around a 20% downpayment, depending on the real estate market or the size of the property. Source 1, Source 2
What are the most important factors to consider when evaluating a multifamily real estate investment?
The most important factors to consider when evaluating a multifamily real estate investment are the desired return on investment (ROI), metrics such as cap rate, cash-on-cash return, internal rate of return (IRR), and equity multiple, and the multifamily market in which the property is located.
ROI is a personal goal that depends on the investor's expectations. Metrics such as cap rate, cash-on-cash return, IRR, and equity multiple are important to understand in order to form ROI goals. It is also important to consider the multifamily market in which the property is located, as properties in some areas may be overpriced or have a low supply. Shopping around in different markets can help an investor find the ideal environment to chase their investment goals.
For more information, please see the following sources:
What are the tax implications of investing in multifamily real estate?
Investing in multifamily properties comes with several tax incentives. It’s possible to deduct operating expenses and maintenance costs, including management fees, insurance, and marketing costs, or any legal and professional services, such as property management companies. Additionally, investors should be aware of potential capital gains taxes when investing in commercial or multifamily property. Strategies such as 1031 exchanges, investing in an Opportunity Fund, and tax-loss harvesting can help investors save money on taxes.
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How can I calculate the internal rate of return for a multifamily real estate investment?
To calculate the internal rate of return (IRR) for a multifamily real estate investment, you can use your Excel software program to input the cash flows net of financing to come up with a valuable equity. You can find more information on how to calculate the IRR here. Calculating the IRR from the get-go can help you evaluate your multifamily real estate opportunities and avoid getting too far in with a project you shouldn’t be involved with.