Internal rate of return (IRR) and return on investment (ROI) are two methods for calculating returns on potential investments.
Understanding the difference between IRR vs ROI in real estate will help you choose effective real estate investing strategies for meeting your investment goals.
What Is IRR?
IRR (internal rate of return) measures the potential profitability of investments using a discounted cash flow analysis. The IRR calculation factors in the time value of money using a discount rate. Discount rates work like interest rates in reverse; rather than calculating the future value of today’s investments, discount rates calculate the present value of future investments.
To demonstrate how discount rates work with the time value of money: how much would you pay today to receive a guaranteed $10,000 one year from now? If you’re using a 10% discount rate, you’d pay $9,090.90 ($10,000 divided by 1.1).
This is the principle that drives the IRR. The IRR tells you what discount rate you can get on your investment based on future cash flow projections, translated into today’s dollars. Generally, the higher the discount rate is, the more profitable the deal is. So, if you’re comparing the IRR for two potential investment properties, the property with the higher IRR would theoretically be the better investment.
Importantly, IRR does not factor in external factors like inflation and the cost of capital. This is where the “internal” part of the “internal rate of return” comes from.
How Is IRR Calculated?
The formula for calculating IRR is as follows:
Courtesy of the Corporate Finance Institute
The result of the IRR calculation equals the discount rate that sets the NPV of future cash flows to $0. This tells you the annualized rate of return, regardless of how long the investment is held, so long as cash flows remain steady, and proceeds are reinvested at the same discount rate.
Example of an IRR Calculation in Real Estate
Let’s say you have $100,000 to invest in real estate, and you want to find a way to earn at least 12% per year for the next five years.
You find an investment opportunity that will provide you with annual cash flows of $12,000 per year. You also expect that you’ll be able to earn a $25,000 profit from the sale of your property in five years based on local appreciation rates.
Would this be a good investment based on your 12% return requirement?
Using a financial calculator, we find that the IRR for this investment is 15.66%. And since this projection is greater than your 12% expectation, this would likely be a favorable investment.
What Is ROI?
ROI (return on investment) is a financial performance metric that measures the profitability of an investment, expressed as a percentage of the amount you invested.
ROI is straightforward because it does not take the time value of money into account. It simply tells you your investment returns, based on your total investment.
It’s important to note that, instead of providing an annual rate of return like IRR, ROI provides a rate of return for the entire project from start to finish. This means that you can’t compare the IRR of one investment to the ROI of another investment (unless the project with the ROI calculation takes exactly one year to complete).
How Is ROI Calculated?
Compared to calculating IRR, calculating ROI is a breeze!
To calculate your ROI, divide your net profit by your total investment amount.
Example of an ROI Calculation in Real Estate
Let’s stick with the figures from our early IRR example: you have $100,000 to invest. You expect to earn $12,000 per year in cash inflows plus $25,000 upon the sale of the property in five years. What is your ROI?
In this example, your net profit is $85,000 ($12,000 times five years plus $25,000 from the sale). And when you divide your net profit by your total investment amount, you get an ROI of 85% ($85,000 divided by $100,000).
But remember, this ROI is for five years. You could divide your 85% ROI by 5 to determine your annualized ROI, which would be 17%.
For more examples, including different real estate investment types, check out how to calculate ROI on real estate investments.
Key Differences Between IRR and ROI
The primary differences between IRR and ROI include the following:
- IRR is far more difficult to calculate; you’ll need to use a financial calculator or software to avoid manual trial-and-error calculations.
- ROI calculates growth over the course of a project from start to finish while IRR calculates the annual growth rate.
- IRR considers the time value of money, while ROI does not.
When to Use IRR vs ROI
ROI is a go-to return formula for investors because it’s quick and easy. Since it takes so little time, many investors use ROI projections as a way to qualify potential investments. They will run this calculation on lots of properties, disqualifying properties that don’t hit their targeted ROI figure.
The properties that remain in contention based on projected ROIs warrant further due diligence, which often includes an IRR analysis. Investors might calculate the IRR on the few properties that are in serious consideration and choose the project with the greatest IRR for their next investment.
Conversely, some real estate investors skip the IRR calculations completely due to the complexity of the formula. Rather than figuring out the net present value of future cash flows, many investors are comfortable comparing the annualized ROIs to choose the investment projects that provide the greatest returns as a percentage of their initial investments.
Find Strong Returns on Your Real Estate Investments
According to Bankrate, the average return on investment in the US for 2021 was 10.6% for residential real estate. Investors who invested with Gatsby Investment that year saw an average annualized ROI of 23.49%!
Gatsby Investment specializes in real estate syndication. Syndication is similar to a crowdfunding model; your investment funds are pooled with funds from other investors, which allows you to access unique, high-value deals with high return potential, all with low minimum investment amounts. And, because Gatsby’s properties are hand-selected and professionally managed by a team of experts, we are able to outperform market averages by a wide margin.
As a Gatsby Investor, you get access to an investor dashboard with transparent property financials. Even before placing your investment, you can project your annualized ROI (based on your investment amount) for any of our investment offerings.
Here is an example of the ROI calculations from one of our current multi-family development projects: