What to Know About Internal Rate of Return (IRR) in Multifamily Real Estate Investing?

Investing in any real estate is a risky business. It is particularly so if you invest in a commercial property. One way to judge whether the real estate you’re thinking of buying is a good investment or not is to compare its IRR with that of other properties.

What is IRR? 

The Internal Rate of Return (IRR) refers to the returns a real estate property generates for the total period of your ownership. 

For example, you’ve bought an apartment complex or an office space, and you plan to retain it for the next 20 years. Now, you get returns on this property each month for the next two decades in the form of the monthly rent. This rental then accumulates interest. So, the money earned in Year One will get an interest for 20 years. The money earned in Year Two will generate interest for 19 years and so on until you reach Year 20 when your rents receive only one years’ worth of interest. This cumulative interest that you earn from your property from the date of purchase to the date of sale is called the Internal Rate of Return. 

This value is called “Internal” rate of return because it only considers the micro-view of the property; that is, only factors like occupancy rate, rental income rates, interest, and so on, and it excludes the macro-view that pertains to factors like inflation rate, currency devaluations, cost of capital, and so on which can affect the total returns.  

Role of IRR in multifamily real estate investing 

IRR, in simpler terms, refers to the amount of interest a commercial property earns on each dollar that you invested in acquiring the property, compounded over the course of the entire duration of time you hold it. 

When it comes to multifamily properties like apartment complexes, the IRR becomes one of the best and most accurate ways to identify the future value of the property.

Take the capitalization rate, for example. While it’s an effective tool, the cap rate only offers insight into the earning potential of a property for a single year. It doesn’t take into consideration any changes that can take place in the rent coming in and the occupancy rates over the course of your ownership. 

On the other hand, the IRR offers an expansive view of how much a real estate investment will be worth in the long run and what the buyer can expect to earn during the time they own the property and finally, the amount they can earn during the sale. 

Additionally, the IRR is more dynamic since it discounts the value of money over a period of time, allowing you to account for changes in rental rates and an increase in vacancies in your multifamily property. This is something that other real estate valuation metrics don’t allow. 

By using the IRR, you’ll get a better insight into the profitability of the multifamily property, and you will be able to make more mindful investment decision. 

– The Multifamily Review Team