How do you calculate IRR in real estate?

Lay out the series

An IRR is a property of a list of dated cash flows and nothing else. Four things go into that list: the equity you put in at close, which is negative because it leaves you; the cash flow each year after operating expenses and debt service; the net proceeds when the property sells; and the timing of each. Everything else is commentary.

The series below is a five year hold on a ten million dollar property bought at a 6.0 percent going in cap rate, financed with a 6,300,000 dollar loan whose annual debt service is 480,000 dollars. It is arithmetic on made up figures, illustrative rather than a market observation, and every row ties to the row above it.

Then solve for the rate

The internal rate of return is the discount rate at which those flows are worth exactly what was paid for them. Discount every future figure back at that rate, add the equity that went in, and the total is zero. On the series above the answer is about 11.7 percent, and the equity comes back as a 1.69x multiple.

There is no closed form to rearrange into. The equation is a polynomial in the discount rate with one term per period, and beyond a handful of periods no general solution exists, so every tool that reports an IRR is iterating. Excel starts from a guess and refines it, which is fast and occasionally fails. A calculator can instead scan for a range where the present value changes sign and halve that range until the answer stops moving, which is slower by an amount nobody perceives and cannot fail to converge.

One consequence of the definition is a free check on any IRR you are handed: discount the series at the quoted rate and the present value should come out at zero. If it does not, the series you were given is not the series the rate was computed on.

Annual, monthly, or dated

The convention matters and it is rarely stated. An annual, end of period IRR treats each year's cash flow as arriving on one day at the end of the year, which is what a memo means by an IRR and what Excel's IRR function computes on an annual column. A monthly series compounded and annualized produces a slightly higher figure for the same deal, because money arrives sooner within each year.

Excel's XIRR takes actual dates and is the more precise tool when flows are irregular, which is normal in development and in any deal with a mid hold refinance. Two people can compute two different IRRs from the same deal simply by choosing different conventions, and neither is wrong. What is wrong is comparing them.

Where the series is usually wrong

Disagreements about an IRR are almost never disagreements about the solver, because every tool agrees once the flows are agreed. They concentrate in four places, and all four sit in the exit and the fine print rather than in the operating years.

• The exit line is a sale price rather than net proceeds. Selling costs and the loan payoff both come out before the equity sees anything, and leaving the loan balance in overstates a levered return enormously
• The exit cap rate is quietly the going in cap rate. Assuming you sell at the yield you bought at is an assumption, not a neutral default, and a quarter point on it moves the answer more than a year of rent growth
• Fees and promote are missing. The project level IRR, the IRR after asset management fees and the IRR a limited partner receives after the promote are three different numbers on one deal
• The equity figure excludes closing costs, the capital funded at acquisition, or a later capital call, all of which are money invested and all of which have to earn the return

When one series has more than one answer

If money goes out, comes back and goes out again, the polynomial can have several real roots and each one is a rate that sets the present value to zero. That happens for real in development draws, in a deal with a capital call after a bad year, and in a refinance that returns capital mid hold ahead of a later shortfall. Most calculators return whichever root they find first and say nothing about it.

When the series changes sign more than once, the honest measure is the net present value at your own required return, which is a single figure whichever root would have been quoted. The free IRR calculator on this site counts the sign changes and says so on the page rather than presenting one root as the answer.

Getting the flows out of the documents

The solving is the easy half. The work is turning a rent roll, a trailing twelve month statement and a debt quote into the cash flow line for each year of a hold, with the rollover, the capital plan and the refinance in the right years. That is underwriting, and it is what Altyst does with the documents a deal already comes with, so the return is run on a model rather than on a summary of one.