Wealth Opportunities in Commercial Real Estate: Management, Financing, and Marketing of Investment Properties

Internal Rate of Return (IRR)

The internal rate of return (IRR) is the discount rate that results when the present value of the project's cash flow equals the initial investment plus the present value of any additional capital contribution. In other words, the IRR for a project is the discount rate when the net present value is zero.

Again, applying this definition to our hypothetical example, at a 13.29 percent IRR, the analysis shows a project value of $3,625,000, which equals the $3,625,000 initial investment.

In Chapter 2 we defined the Cap Rate as the NOI divided by the FMV and Return on Equity as the Net Cash Flow divided by the equity investment. In both of these calculations, the result of one year's figures were used. When calculating IRR, the idea is to look at the cash flow coming from several years and ask the question: what rate of return is required to grow the original investment so that it achieves the given cash flow and return of principle? In other words, what percentage should you use to discount the present value of the income stream so that it equals the original investment plus the present value of any additional investment? You need not discount the original investment since it already is at time period zero.

Rule Number 11

The higher the discount rate, the lower the present value. When buying, seek a high discount rate, a high IRR. When selling, aim at a low discount rate, a low IRR.

As can be seen in Exhibit B.1, there is an inverse relationship between ...