Internal Rate of Return
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Hi Helen,helen said:could someone explain the term: Internal Rate of Return.What is the relevance of this concept in terms of property investment.
In his book "Extraordinary Profits From Ordinary Properties", Dolf De Roos defines IRR as :
"The cash flow sequence during a period of ownership. This will comprise the cash deposit, the net after-tax cash in or cash out each year, and the build up in equity, all the while taking the time value of money into account".
T.
It is the interest rate which, when used as the discount rate for a series of cash flows, gives a net present value of zero. In other words, if we assume that we invest some money now (giving us an initial negative cash flow figure) and get some cash flows back in the future (giving us positive cash flow figures), it is the overall rate of growth on the investment.
http://www.google.com.au/search?hl=en&q=define:+internal+rate+of+return&meta=lr=lang_en
http://www.google.com.au/search?hl=en&q=define:+internal+rate+of+return&meta=lr=lang_en
Another way of putting it would behelen said:Thanks Glebe,
for your explanation.
After reading the definition by Dolf de Roos:
all I could say is "WHAT THE....."
Thanks Tandella for trying to explain IRR. Dolf's definition enters the realm of "please explain!!"
"What is the equivalent interest rate you would get if you had put the same money into the bank".
That covers all money you have to take out of your pocket, and the timing. The return covers rent as well as the rise in home value.
So for instance you put a deposit and initial expenses of $50K on a house worth $200K. If the rent was exactly the same as bank interest, and you received all rent on the day bank interest was due (to simplify), and you had no other expenses- and the house was worth $250K 12 months later. Your gain is $50K based on $50 you are out of pocket- so the return was 100% on your cash for that year.
If you want to be more realistic, and take into account negative or positive gearing and all other expenses associated with the property, you can use Ian Somers' PIA software. That will give you a reasonably accurate number.
Why does everyone make IRR sound so complex? Keeping it simple and as applied to property investing, I thought it was rental return added to capital growth.
eg: If you are acheiving 7.5% rental yield and 10% growth per year, your IRR would be 17.5%.
That Dolf De Roos explanation is ridiculous.
eg: If you are acheiving 7.5% rental yield and 10% growth per year, your IRR would be 17.5%.
That Dolf De Roos explanation is ridiculous.
likewow said:
This is a description of gross return - see Somers (More Wealth from Residential Property, p64).
IRR is more complex.
The same book has a section on IRR.
Quoting from p251, 'working out the IRR on any investment is basically a matter of analysing what you put in compared to what you get back at the end.'
Important factors include rental yield, capital growth, holding costs, your tax situation, inflation, etc.
Regards, Peter
Glebe said:
Right on Glebe.
IRR is a well established technique in the analysis of investments (and cashflows).
Basically the higher the IRR the more "robust" a series of cashflows.
That is, the larger the IRR the greater the need to discount future cash flows to give the overall cash flow stream (including negative cash flows) a Present Value (PV) of zero.
IRR can be used as a measure of the financial viability of a project (given financing costs). The calculated IRR can be compared to a predetermined interest rate typically based on market rates of interest. If the IRR (say, 15%) exceeds the predetermined discount rate (say, 12%), then the project is worthwhile, otherwise not.
MB
Pitt StPitt St said:
I googled to find something in plain English- but all I found were definitions containing words that a non economist like me cannot understand. My explanation is based on Dolf deRoos' extensive explanation on his CD course. Can you explain your definition a little more in layman's terms please?
[***** Edit ***** a few more definitions]
http://www.invest-2win.com/irr.html
http://toolsformoney.com/rental.htm
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Does internal rate of return take into account inflation and interest rates?.
It might be better to use an simplified example. I buy a property at 200k with a 10% deposit (20K). It appreciates in value 10% that year (200k to 220k). Rents are $200 a week and interest repayments on loan are $250 a week. Depreciation+negative gearing tax writeoff and maintainence are both $500 for the year so cancell each other out in a cashflow sense. So negative cashflow is $50 a week or $2700 a year. So money into the deal was the $20k deposit plus the $2700 negative cashflow. Money out of the deal is the $20k appreciation in the property. So would you therefore say that the I.R.R for the year is $20,000 (money out) devided by $22,700 (money in) or 88% for the year?. Is that right or is there further calculations for a fall in the value of money in that year (inflation).
Say you borrow all of the purchase plus costs (borrowing against equity). So deposit is 0%. Net incoming cashflow (rents + depreciation + negative gearing tax writeoffs) is still $200 a week. But because you borrowed all of the purchase price net outgoing cashflow (interest + maintainence, etc) is now $300 a week instead of $250. So end of year negative cashflow is now $5400 instead of $2700. Then the money put into the property over the 12 months is $0 deposit + net $5400 negative cashflow. Money out is the $20k capital apprecation as per the first example. Therefore money out ($20k) devided by money in ($5400) = an I.R.R for the year of 370%.
Am I using a realistic example? and do I have the right definition of internal rate or return or are there other factors such as inflation to be taken into account?
It might be better to use an simplified example. I buy a property at 200k with a 10% deposit (20K). It appreciates in value 10% that year (200k to 220k). Rents are $200 a week and interest repayments on loan are $250 a week. Depreciation+negative gearing tax writeoff and maintainence are both $500 for the year so cancell each other out in a cashflow sense. So negative cashflow is $50 a week or $2700 a year. So money into the deal was the $20k deposit plus the $2700 negative cashflow. Money out of the deal is the $20k appreciation in the property. So would you therefore say that the I.R.R for the year is $20,000 (money out) devided by $22,700 (money in) or 88% for the year?. Is that right or is there further calculations for a fall in the value of money in that year (inflation).
Say you borrow all of the purchase plus costs (borrowing against equity). So deposit is 0%. Net incoming cashflow (rents + depreciation + negative gearing tax writeoffs) is still $200 a week. But because you borrowed all of the purchase price net outgoing cashflow (interest + maintainence, etc) is now $300 a week instead of $250. So end of year negative cashflow is now $5400 instead of $2700. Then the money put into the property over the 12 months is $0 deposit + net $5400 negative cashflow. Money out is the $20k capital apprecation as per the first example. Therefore money out ($20k) devided by money in ($5400) = an I.R.R for the year of 370%.
Am I using a realistic example? and do I have the right definition of internal rate or return or are there other factors such as inflation to be taken into account?
I'll see what I can manage Geoff.
Ok.... consider a series of Cashflows.
Initially these cashflows are negative (expenses exceed income).
Then later they are positive (income exceeds expenses).
Example......
Year 1 - ($20,000) [minus $20,000]
Year 2 - $5,000
Year 3 - $7,500
Year 4 - $10,000
Year 5 - $10,000
Net Cash Flow = $12,500
Now anybody can look at that series of cashflows and ascertain that the net cash-flow is $12,500 (-20 + 5 + 7.5 + 10 + 10).
But what that simple add does not tell us how robust that future positive cashflow is.
We all know that inflation erodes the value of a future dollar.
So what the IRR does is tell you (effectively) at what rate of inflation (what discount rate) would the sum total of that series of cashflows have a Present Value (PV) of zero.
Taking the same series of cash flows (and in my case using MS Excel) we can calcuate the following:
Year 1 - ($20,000) [minus $20,000]
Year 2 - $5,000
Year 3 - $7,500
Year 4 - $10,000
Year 5 - $10,000
Net Cash Flow = $12,500
Internal Rate of Return = 20%
The IRR calculation tells us that for this particular series of cash flows, a discount rate of 20% is required to give them a PV of zero.
But inflation is not anywhere near 20% you say!
True..... but this does not mean that the IRR is any less valid.
In my last post I said that the "IRR can be used as a measure of the financial viability of a project (given financing costs). The calculated IRR can be compared to a predetermined interest rate typically based on market rates of interest. If the IRR (say, 15%) exceeds the predetermined discount rate (say, 12%), then the project is worthwhile, otherwise not."
In my little series of cashflows I have an IRR of 20%, but what it it was much lower - say 5%
Would this make the project worthwhile?
Well, CPI is currently running at 2.5% pa and the RBA does aim to keep it at between 2 - 3% over the course of the business cycle - so no problem there.
But what about financing and the opportunity cost of that money?
5% may be above what CPI will reach over the investment period, but it is less than you can get in an at-call account and it is also less than the interest rate in the overnight cash market (5.25%) - so in both those cases the investment would fail to be economically viable.
So how much is needed to make a project worthwhile?
Well, over and above CPI / the cost of finance / the opportunity cost of putting money elsewhere, it really is up to the individual investor as to how much IRR they require before an investment alternative becomes viable.
I have heard anecdotal stories that some people require a min IRR before they proceed with an investment, but each to their own.
MB
Ok.... consider a series of Cashflows.
Initially these cashflows are negative (expenses exceed income).
Then later they are positive (income exceeds expenses).
Example......
Year 1 - ($20,000) [minus $20,000]
Year 2 - $5,000
Year 3 - $7,500
Year 4 - $10,000
Year 5 - $10,000
Net Cash Flow = $12,500
Now anybody can look at that series of cashflows and ascertain that the net cash-flow is $12,500 (-20 + 5 + 7.5 + 10 + 10).
But what that simple add does not tell us how robust that future positive cashflow is.
We all know that inflation erodes the value of a future dollar.
So what the IRR does is tell you (effectively) at what rate of inflation (what discount rate) would the sum total of that series of cashflows have a Present Value (PV) of zero.
Taking the same series of cash flows (and in my case using MS Excel) we can calcuate the following:
Year 1 - ($20,000) [minus $20,000]
Year 2 - $5,000
Year 3 - $7,500
Year 4 - $10,000
Year 5 - $10,000
Net Cash Flow = $12,500
Internal Rate of Return = 20%
The IRR calculation tells us that for this particular series of cash flows, a discount rate of 20% is required to give them a PV of zero.
But inflation is not anywhere near 20% you say!
True..... but this does not mean that the IRR is any less valid.
In my last post I said that the "IRR can be used as a measure of the financial viability of a project (given financing costs). The calculated IRR can be compared to a predetermined interest rate typically based on market rates of interest. If the IRR (say, 15%) exceeds the predetermined discount rate (say, 12%), then the project is worthwhile, otherwise not."
In my little series of cashflows I have an IRR of 20%, but what it it was much lower - say 5%
Would this make the project worthwhile?
Well, CPI is currently running at 2.5% pa and the RBA does aim to keep it at between 2 - 3% over the course of the business cycle - so no problem there.
But what about financing and the opportunity cost of that money?
5% may be above what CPI will reach over the investment period, but it is less than you can get in an at-call account and it is also less than the interest rate in the overnight cash market (5.25%) - so in both those cases the investment would fail to be economically viable.
So how much is needed to make a project worthwhile?
Well, over and above CPI / the cost of finance / the opportunity cost of putting money elsewhere, it really is up to the individual investor as to how much IRR they require before an investment alternative becomes viable.
I have heard anecdotal stories that some people require a min IRR before they proceed with an investment, but each to their own.
MB
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The relevance of IRR to property investing, or any investing for that matter (eg. shares), is it shows how hard your *cash* is working for you.
Other measures of investment performance, such as Yield and Growth, whilst being useful measures in themselves, do not specifically show how hard your cash is working for you in the investment. This is the cash you have tied up in the property (deposit, legals), plus any additional cash you are contributing along the way (if you are negatively geared).
"Cash on cash return" is another term used to express the same (or similar) concept.
The IRR calculation produces one single percentage rate that when applied to all the cash inflows (rent, capital gains on sale, tax refund) and cash outflows
(deposit, legals, loan interest, rates, maintenance, repairs), results in a zero result (the nett-present value of zero).
Time is an integral part of the calculation because getting $10,000 today is worth more than getting $10,000 in 3 years time whilst paying $10,000 today is costlier than paying $10,000 in 3 years time.
Therefore, for example, an investment that requires a $5K contribution at the beginning of each year for 4 consecutive years and returns $50K at the end of the fifth year will produce a higher IRR than an investment which demands $20K up-front and returns $50K after five years. In the second case more of your money is locked up sooner so the rate of return is less (20% versus 28.5% to be exact).
All monies contributed towards a property, and the time at which they are contributed, therefore have the potential to affect the IRR. The IRR can therefore serve as the basis of evaluating many potential "what if" scenarios purely in terms of how the scenario affects the IRR.
For example, consider a $300K property. Assume for simplicity that if you put up 10% deposit ($30K), you have a neutrally geared property. If you sell for $350K after 10 years that is an IRR of 10.3%. Let's say you instead put up a 5% deposit ($15K). You would no longer be neutrally geared, because the loan is higher hence the interest bill is higher. At 7% interest rate, you have to pay $1050 per year out of your own pocket. The IRR is now around 15%, because you have put less of your money to work to achieve the same outcome, and you have paid out that money later.
Another example might be "buy and rent as-is" versus "buy, renovate, and rent". The renovation is going to cost up-front money and should translate to[hopefully] both a higher weekly rental and [also hopefully] a higher final sales price. Plugging the revised numbers into an IRR calculation can show whether it improves the IRR or not. PIA would be useful in this regard, but a spreadsheet will probably also do an adequate job.
Other measures of investment performance, such as Yield and Growth, whilst being useful measures in themselves, do not specifically show how hard your cash is working for you in the investment. This is the cash you have tied up in the property (deposit, legals), plus any additional cash you are contributing along the way (if you are negatively geared).
"Cash on cash return" is another term used to express the same (or similar) concept.
The IRR calculation produces one single percentage rate that when applied to all the cash inflows (rent, capital gains on sale, tax refund) and cash outflows
(deposit, legals, loan interest, rates, maintenance, repairs), results in a zero result (the nett-present value of zero).
Time is an integral part of the calculation because getting $10,000 today is worth more than getting $10,000 in 3 years time whilst paying $10,000 today is costlier than paying $10,000 in 3 years time.
Therefore, for example, an investment that requires a $5K contribution at the beginning of each year for 4 consecutive years and returns $50K at the end of the fifth year will produce a higher IRR than an investment which demands $20K up-front and returns $50K after five years. In the second case more of your money is locked up sooner so the rate of return is less (20% versus 28.5% to be exact).
All monies contributed towards a property, and the time at which they are contributed, therefore have the potential to affect the IRR. The IRR can therefore serve as the basis of evaluating many potential "what if" scenarios purely in terms of how the scenario affects the IRR.
For example, consider a $300K property. Assume for simplicity that if you put up 10% deposit ($30K), you have a neutrally geared property. If you sell for $350K after 10 years that is an IRR of 10.3%. Let's say you instead put up a 5% deposit ($15K). You would no longer be neutrally geared, because the loan is higher hence the interest bill is higher. At 7% interest rate, you have to pay $1050 per year out of your own pocket. The IRR is now around 15%, because you have put less of your money to work to achieve the same outcome, and you have paid out that money later.
Another example might be "buy and rent as-is" versus "buy, renovate, and rent". The renovation is going to cost up-front money and should translate to[hopefully] both a higher weekly rental and [also hopefully] a higher final sales price. Plugging the revised numbers into an IRR calculation can show whether it improves the IRR or not. PIA would be useful in this regard, but a spreadsheet will probably also do an adequate job.
