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This week we’re going to look at the metrics internal rate of return (“IRR”) and return on investment (“ROI”). These are just two of the calculations frequently used by property investors to analyse and forecast the actual and expected returns from multi-family or BTR-SFR investments.
Internal Rate of Return and Return on Investment
Let’s start by examining what these metrics are all about
IRR and ROI are not the same and are actually complementary calculations investors use when measuring the investment return on a multi-family or BTR-SFR property investment. They are both widely used but the biggest difference between them is that the IRR calculation takes into account the time value of money (“TVM”) whereas ROI (not to be confused with “return of investment”) does not.
Fundamentally, the TVM concept means that money actually in hand today is worth more than the same amount of money at a future date because of the effects of interest rates inflation. Money in hand today can be invested to generate earnings and this has a compounding effect on the original amount invested.
Conversely, having the right to receive money in the future carries a certain amount of risk—this is one of the main reasons why borrowers are required to pay interest on loans they obtain from lenders.
Return on Investment calculation
ROI measures the change in the value of a property value at a point in time compared to its original value, ie:
Return on Investment calculation
ROI measures the change in the value of property value at a point in time compared to its original value, ie:
ROI measures the change in the Value of property at acquisition / Value of property at acquisition x 100
Current value of property ($1,250,000) – Value of property at acquisition ($1,000,000) / Value of property at acquisition ($1,000,000) x 100 = 25% ROI
Although this calculation does not take into account two important factors:
- the holding period of the property;
- the timing of receiving the net income cash flows
Internal Rate of Return
IRR (or “annualised returns”), on the other hand measures cash flows generated by multi-family or BTR-SFR investments over holding periods longer than one year.
Calculating IRR is complex and measures the annual growth of an investment while factoring in the time value of money.
The IRR calculation determines the specific discount rate which makes total cash inflow equal to the net present value (“NPV”), or the initial amount of net cash invested into the property.
To calculate NPV the formula is: cash inflows divided by (1 + i)t – cash outflows
(“i” is the required discount rate and “t” = the number of cash flow periods).
If the projected future discounted cash flows are greater than the cost of the investment, or NPV is positive, then investing in the multi-family or BTR-SFR property is worthwhile.
The discount rate represents an investor’s return from a relatively risk-free investment, that is, if an investor can earn an IRR of 5% from a relatively safe investment, a higher IRR would be required if there is an alternative investment carrying slightly more risk.
The IRR formula is also used by professional investors such as private equity, hedge funds and syndicated property investors.
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Return on Investment or Internal Rate of Return
As mentioned, IRR calculates the annualised growth rate and takes into account the TMV which means that the longer an investment is held the lower the IRR will be.
ROI measures the total return from the start of to the end of the investment period ROI provides a macro level overview of the investment return. However, it does not take into account when income is received. Accordingly, ROI will be the same, whether a property is held for 1 or 10 years because the calculation assumes net income cash flows are received as one lump sum.
For example, a multi-family or BTR-SFR property acquired for $400,000 which is worth $600,000 after one year would show an ROI of 50% and an IRR of 50%. However, after a 5 year holding period, due to TVM, the IRR may only be 12% whereas the ROI would still be 50%.
Why use both ROI and IRR?
ROI is an easy, macro level calculation and, often, can be used to undertake an initial screening of multi-family or BTR-SFR properties which may not be compatible with an investor’s strategy. Investment opportunities which pass the first screening can be further analysed with a detailed IRR calculation to assess opportunity cost and the time value of money.
In short, using both ROI and IRR calculations enable real estate investors to obtain in-depth insight into the past, current, and potential future performance of multi-family or BTR-SFR rental properties.
CPI Capital uses a variety of metrics to carefully assess and analyse all of the REPE investments which are offered to us or we source. An initial ROI assessment can help eliminate many of the projects which don’t work for us financially and allow us to spend our time and course looking at those which have potential.
We then calculate the IRR so that our passive investors can be sure that we only focus on projects most likely to meet our investment return hurdle rates.
Our team at CPI Capital are experienced real estate investors, both in multi-family and BTR-SFR assets and we always do complete in-depth research to seek the maximum rewards for our partners and passive investors!
CSO, COO, Co-Founder CPI Capital