Internal Rate of Return (IRR) in real estate is the annualized percentage rate that makes the present value of all cash flows from a property (inflows and outflows) equal to zero. Practically, IRR answers: “If I invest X today and receive these cash flows over the holding period, what single yearly return does that sequence imply?”
Real estate deals typically involve uneven cash flows over several years (NOI, capex, refinancing, sale proceeds). IRR lets investors compare opportunities with different timing, sizes, and durations by converting the whole cash‑flow stream into one annualized rate — useful when ranking projects or screening deals against a required return.
IRR discounts future cash flows to account for the fact that a dollar today is worth more than a dollar tomorrow. Unlike simple ROI or cash‑on‑cash, IRR penalizes late cash flows and rewards earlier returns because it compounds returns year‑to‑year.
IRR is the discount rate (r) that satisfies: 0 = Σ (Ct / (1+r)^t) − C0, where C0 is the initial outlay and Ct are subsequent net cash flows. In words: IRR makes Net Present Value (NPV) equal zero.
Common Excel functions:
Typical input setup: column A = dates (or Year 0..n), column B = cash flows (negative for outflows). For IRR: =IRR(B2:B8). For XIRR: =XIRR(B2:B8,A2:A8).
Unlevered IRR measures the property’s performance regardless of financing. Include acquisition price (cash out), operating cash flows (NOI less capex and operating reserves), periodic capex, and net sale proceeds (sale price less selling costs and closing costs).
Levered IRR measures investor equity returns after debt. Include equity invested at acquisition, annual debt service (interest and principal as paid), equity used for capex or reserves, net proceeds to equity at refinancing or sale (sale proceeds minus outstanding loan balance), and any additional equity raises.
Pre‑tax IRR is useful for asset‑level comparisons and underwriting. After‑tax IRR accounts for taxes, depreciation recapture, and investor tax status — required when reporting expected investor returns to LPs. Show both when possible and clearly label which is presented.
Model irregular or lumpy items explicitly in the period they occur. Use XIRR when cash flows are not evenly spaced. Break out tenant improvement (TI) and leasing commission (LC) costs with the exact dates they’re incurred to avoid understating short‑term capital needs.
Unlevered IRR: return on the asset ignoring financing — reflects asset value creation. Levered IRR: return to equity after financing — reflects investor experience, risk, and capital structure.
Leverage magnifies returns (both positive and negative). If the property cash flows and exit price outperform the cost of debt, levered IRR will exceed unlevered IRR. But leverage increases risk: default risk, refinancing risk, and sensitivity to small changes in exit price or cash flows.
Use unlevered IRR to compare intrinsic asset performance or when evaluating buyers with different financing. Use levered IRR when judging investor equity returns, raising capital, or negotiating with LPs because it reflects the actual cash returned to investors.
“Good” is relative: core/core‑plus deals may target single‑digit to low‑teens IRR; value‑add typically targets mid‑teens; opportunistic or development targets higher IRRs (20%+). Compare IRR to strategy benchmarks, risk profile, market, and alternative uses of capital.
IRR implicitly assumes interim cash flows are reinvested at the IRR itself — often unrealistic. For short, high‑return flips, IRR can look extreme even if total dollars returned (ROI) is modest. Use MIRR or NPV (with a realistic reinvestment rate) when reinvestment assumptions matter.
IRR is very sensitive to timing (when cash arrives) and the terminal sale price (driven by exit cap rate). Small changes in exit cap rate or sale timing can swing IRR several percentage points, so always run sensitivity tables.
Non‑conventional cash flows (multiple sign changes) can produce multiple IRRs or none. MIRR removes the multiple‑IRR ambiguity by using explicit finance and reinvestment rates. NPV at your required discount rate provides an absolute decision rule (accept if NPV>0).
ROI / total return = total profit / initial investment (doesn't annualize or account for timing). Cash‑on‑cash = annual cash before/after debt divided by equity invested (a simple yield measure). IRR annualizes the whole cash‑flow stream and incorporates timing; use all metrics together.
Cap rate is a snapshot valuation metric: NOI / value. It helps set purchase or exit price assumptions. IRR is a multi‑year return measure that uses cap rate assumptions when estimating terminal sale price. (See more on cap rate.)
NPV tells you the dollar value created at a chosen discount rate; IRR gives the breakeven discount rate for that cash flow. Use IRR to compare returns and NPV to assess value creation for a given cost of capital.
Taxes reduce after‑tax cash flows; depreciation can shield income early but triggers recapture on sale. Include tax payments and expected recapture at sale when presenting after‑tax IRR. Also include selling costs (broker fees, legal) which reduce terminal proceeds and IRR.
Professional management fees, asset management/advisory fees and sponsor promote reduce investor cash flows. Model them explicitly (as annual line items and carried interest at exit) so the presented IRR reflects true investor returns.
Refinancing proceeds returned to equity or used to pay down debt should be modeled as cash flows in the period they occur. Additional equity raises are outflows to equity. Track cumulative equity invested and returned across periods.
Create a two‑way sensitivity table with exit cap rate on one axis and rent growth (or NOI margin) on the other. Compute IRR for each cell to show how IRR shifts across realistic ranges.
Define three scenarios with assumptions for rent growth, vacancy, capex, and exit cap rate (e.g., base = current market, best = faster rent growth + lower exit cap rate, worst = higher cap rate + higher capex) and report IRR, NPV, and cash‑on‑cash for each.
Ask for the assumptions behind marketed IRRs. Recreate the model, push exit cap rate and rent down by modest amounts, and re‑run IRR. If a slight adverse move destroys the IRR, the marketed figure is fragile.
Typical institutional benchmarks (illustrative): core ~6–9% IRR; core‑plus ~8–12%; value‑add ~12–18%; opportunistic/development 18%+. Benchmarks vary by market and risk tolerance.
Multifamily and industrial frequently show lower risk and slightly lower IRRs than opportunistic office or retail turns. Development or adaptive‑reuse projects typically target the highest IRRs to compensate for construction and leasing risk.
Adjust target IRRs upward for secondary or tertiary markets, thinly traded assets, or higher political/regulatory risk. Primary markets with liquidity and strong demand support lower required IRRs.
Example (annual): Year0 = -$123,400; Year1 = $36,200; Year2 = $54,800; Year3 = $198,100 (includes sale). In Excel place these in cells B2:B5 and use =IRR(B2:B5) → result ≈ 18% (annual IRR). If cash flows occur on exact dates in column A, use =XIRR(B2:B5,A2:A5).
Keep a clear inputs/assumptions section, label whether IRR is levered/unlevered and pre/after‑tax, and version control models. Use templates with scenario tabs and sensitivity tables. Many free templates and calculators exist — adapt them and always audit formulas.
Always disclose: holding period, exit cap rate and how exit price was calculated, rent growth and vacancy assumptions, capex timing/amounts, fees (asset management, acquisition, disposition), financing terms, and whether IRR is pre‑tax or after‑tax.
Show a small table with unlevered IRR, levered IRR, cash‑on‑cash, MOIC (multiple on invested capital), and NPV at the target discount rate. Label each metric clearly so investors can compare asset vs equity performance.
IRR assumes interim cash flows are reinvested at the IRR itself; MIRR uses explicit finance and reinvestment rates to provide a single, more realistic return when reinvestment assumptions matter.
Negative IRR occurs when cumulative discounted outflows exceed inflows. Multiple IRRs can occur if the cash‑flow stream changes sign more than once (non‑conventional cash flows). Use MIRR or NPV to resolve.
Not blindly. Short‑term flips can show high IRRs because returns are compressed into a short window — but the absolute dollar gain (MOIC) and transaction costs, taxes, and execution risk matter. Check both IRR and total cash multiple.
Purchase: value‑add multifamily at $2,000,000. Equity required = 25% ($500,000); loan = $1,500,000 (interest‑only at 5% with principal due at sale). Hold = 5 years. Stabilized Year1 NOI = $150,000; NOI grows ~3%/yr. One mid‑hold capex of $40,000 in Year3. Exit cap rate assumption = 6% (base).
Unlevered cash flows (annual): Year0 = -$2,000,000; Year1 = $150,000; Year2 = $154,500; Year3 = $159,135 − $40,000 capex = $119,135; Year4 = $163,909; Year5 = $168,826 + sale proceeds.
Sale price = Year5 NOI / 6% = $168,826 / 0.06 = $2,813,772. Selling costs 2% → net sale ≈ $2,757,498. Year5 total = $168,826 + $2,757,498 = $2,926,324.
Unlevered cash stream: [-2,000,000; 150,000; 154,500; 119,135; 163,909; 2,926,324]. Using Excel =IRR(range) gives unlevered IRR ≈ 13.2% (annualized). Plain English: if you owned the asset outright, the sequence of operating income, capex, and a sale at a 6% cap produces about a 13% annual return on the capital deployed.
Levered cash to equity (interest‑only loan at 5%): equity outlay Year0 = -$500,000; Year1 = $150k − $75k interest = $75k; Year2 = $79,500; Year3 = $44,135 (after capex); Year4 = $88,909; Year5 = $93,826 + net sale after repaying $1.5M debt ≈ $1,351,324. Using =IRR(range) on equity cash flows yields levered IRR ≈ 31%.
Raise exit cap rate to 6.5% → lower sale price: Sale ≈ 168,826 / 0.065 = $2,596,563 (net after 2% selling costs ≈ $2,544,632). That reduces Unlevered IRR several percentage points (≈ 11–12% instead of 13.2%) and levered IRR more (roughly in the high‑20s). A one‑year longer hold delays the big terminal cash flow and meaningfully lowers IRR because IRR rewards faster returns.
“Based on a 5‑year hold, conservative 3% NOI growth, and a 6% exit cap rate, the asset‑level (unlevered) IRR is ~13.2%. With our 75% loan (interest‑only at 5%), the projected return to equity is ~31% IRR, driven mainly by the leveraged terminal sale proceeds. Assumptions include a one‑time $40k capex in Year3 and 2% selling costs. We also ran sensitivity scenarios (exit caps 5.5%–6.5%) — the equity IRR ranges from approximately 25%–36% depending on market movement. See the accompanying sensitivity table and tax/fee disclosures.”
Use IRR to compare multi‑year deals and investor returns. Use NPV when you have a known cost of capital and want dollar value creation. Use cap rate for valuation snapshots and cash‑on‑cash/MOIC to communicate immediate income yield and absolute multiple to investors.
Use Excel templates with separate inputs and outputs tabs, XIRR for irregular cash dates, and MIRR where reinvestment should be explicit. Recommended topics to read next: NPV vs IRR, cap rate dynamics, debt structuring, and tax impact on returns.
If you want, I can now: (A) draft the short plain‑English IRR explanation with a numeric example and the exact Excel formula, or (B) produce a checklist of cash flows to include when calculating real estate IRR. Which would you prefer?
