All concepts within Real Estate Investing can be broken down into objective and subjective; I’ve written about this extensively on many occasions. The objective side of things all about math; you put the numbers on in the spreadsheet, and the deal either works or it doesn’t.
The subjective elements are more difficult because these are a matter of perspective, which comes with experience. In other words, just because the numbers look good, doesn’t necessarily mean that the deal is good and you should buy it – there’s much more to it indeed.
Internal Rate of Return (IRR)
Today, I want to focus on an element which is a little of both – the Internal Rate of Return. The IRR is just a formula, a calculation like so many others in real estate investing. But, there is a perspective behind this particular calculation which is more sophisticated and in-depth than most other metrics that we use.
In order to understand the IRR, let us take a step back and discuss the Cash on Cash Return (CCR) first…
Cash on Cash Return – CCR
The most easily understood metric of investment return in real estate is Cash on Cash Return, usually abbreviated either CCR or COC. The concept is rather simple – CCR juxtaposes the cash investment that has been made to the Cash Flow (Income minus Expenses) being received.
For example, let’s say you invest $100,000 cash to buy a 4-plex which generates $2,000/month of Gross Income which results in $1,200/month of Cash Flow. Since CCR is usually thought of in terms of annual return, we must multiply all of the monthly numbers by 12. Thus, this $100,000 4-plex is generating $14,400 of Annual Cash Flow.
Now, CCR is simply the answer to the question – if I invest $100,000 in this 4-plex, how quickly, or at what rate, would I recover my cash?
Framed in this way, all we basically aim to find out is what percentage of $100,000 does $14,400 represent. In mathematical terms, if $100,000 is 100%, then $14,400 is x – at which point we solve for x:
X (CCR) = $14,400 / $100,000 = 14.4%
Thus, having paid $100,000 and received $1,200/month of Cash Flow, our achieved CCR is 14.4%.