When it comes to evaluating and forecasting your real estate investment’s performance, you’ve got two common tools: internal rate of return (IRR) and return on investment (ROI). While they are complimentary, they’re different. If your aim is to enter the world of commercial real estate, then you should understand these metrics and how they compare.
Keep reading for the difference between the internal rate of return and return on investment.
Internal Rate of Return
Expressed as a percentage, this metric is commonly used to gauge the likely profitability of a venture or to assess the performance of an existing project.
A feature of IRR, which is really another term for annualized return, is the ability to determine the potential value of a property as though it were valued in today’s dollars. The premise is that if you have a solid idea of what a project will be worth, and what it would bring today, you can compare that to your total investment to gain a good sense of your investment risk.
The exact formula is complex – it includes terms such as holding period, net present value (NPV), and cash flow – so we won’t go into it here. Investors don’t usually do the calculations manually, anyway. Instead, they use a financial calculator, a digital internal rate of return calculator, or Excel.
What’s important to note is that the calculation is used to learn the exact discount rate that renders total cash inflow equal to NPV, or the initial sum of invested net cash. Projects with a positive NPV usually get the green light, since projected discounted cash inflows exceed the investments’ cost. The same discount rate can be applied to alternative investment options, by the way, to help investors with decisions there, too.
It also should be noted that since IRR factors in the time value of money (TVM), the IRR will drop commensurate with the amount of time the investment is held.
Return on Investment
This metric assesses the current change in property value as compared with its original value. What return on investment doesn’t do, unlike IRR, is include the time value of money. It also doesn’t account for the length of the property holding period or when net income cash flows are received.
Say you have a project that you bought for $200,000, and it’s now worth $300,000. The return on investment is 50 percent. Quite a simple calculation.
The Difference Between IRR and ROI
Let’s say from the outset that because the ROI is easier to calculate, that tool is more widely used. However, ROI does not consider the future value of investment capital.
Also, while IRR and ROI results can be comparable over 12 months, their differences will manifest when sized up over longer periods.
There are other differences as well. For one thing, while IRR provides an annualized return, ROI will give you a start-to-finish larger view of the investment return.
Also, while IRR accounts for return amounts and timing, ROI does not. To illustrate, there’s a sizable difference between getting $10,000 annually for five years and getting $50,000 in the fifth year. Right?
Ultimately, the differences between IRR and ROI boil down to, as the saying goes, six in one hand, a half-dozen in the other. In other words, there are strengths and weaknesses with both. As we say, ROI is easy to figure but doesn’t consider opportunity cost or time value of money. IRR, while more involved, formula-wise, offers a superior idea of a project’s long-term potential.
The author Allan Smith is a professional finance writer specializing in personal finance. He has worked in the finance sector for a long time. He believes that everyone’s economic and life situation is isolated, and he keeps this fact in mind while providing personal finance advice in his blog Day to Day Finance. All the people seeking financial guidance are in different stages of life. Allan loves to explore every possible angle of personal finance so that anybody can get help.