Want to know if a project is worth investing in? The internal rate of return is just what you need, as it will help you out whenever you need objective data to make your decision.
And it is that This metric is especially useful if you are looking to invest in real estate. and you need to evaluate the profitability of a real estate development, to take firm steps based on figures.
However, the IRR isn't exclusive to this sector, so you can use it to calculate the profitability of different projects. If you're not familiar with how to use it, we'll teach you everything you need to know.
What is the Internal Rate of Return (IRR)?
The Internal Rate of Return is a formula that allows you to calculate the annual profitability of a project. That is, measures the viability of an investment to know whether it will generate profits or not, which is key for investors and companies that need to make informed decisions.
In short, we can say that the IRR is a very useful calculation for determining the expected growth rate for a specific investment over a period of one year or more.
Hence It works like a discount rate, That is, it allows you to calculate the value of the income you will obtain at the end of the investment, taking the current value of the money as a reference.
This is very important because helps you choose those projects that are truly lucrative for you.
What is the purpose of calculating the Internal Rate of Return?
The Internal Rate of Return (IRR) is used to select projects with growth potential that provide benefits over time and to rule out those that waste time or money.
In general, this excellent metric can be useful for:
- Choose from several financing options, those that really have growth potential and are therefore favorable for your company.
- Reduce risks when investing in real estate projects, since you have a calculation at hand that helps you make a good selection.
- Present reports with objective data to other businesspeople or decision-makers involved in the process.
- Determine the long-term financial viability of a project, taking into account all cash flows associated with the project, not just the initial or final profits.
IRR formula
Although the IRR formula may seem a little daunting at first glance, it's not that complicated. You just need to understand each of its variables and everything will become easier when you use it:
Where:
- VAN: is the Net Present Value or Net Present Value
- t: constitutes the period of time
- n: total number of periods
- Ft: net cash flow over the period of time
- I0: total cost of the initial investment
- IRR: represents the Internal Rate of Return.
This formula we shared with you earlier is the original. If you notice, the IRR is calculated by setting the Net Present Value equal to zero, since they are two closely related variables.
It is important to note that You need to determine the internal rate of return using a financial calculator. where you only have to enter it with its values to obtain the result because if you use a basic calculator it will give you an error and you will not be able to know the value of the IRR.
You also have the option of learning how to solve it in an Excel spreadsheet or by hand, since it is not that difficult.
You just have to follow the order of the equation and prioritize the operations enclosed in parentheses and use a standard calculator to perform each of its operations.
How to calculate the IRR?
To calculate the Internal Rate of Return, it's best to proceed step by step so you don't get confused and arrive at the correct result. Keep this order in mind when doing so:
- Simplify the IRR formula and set it equal to zero. so that the NPV is 0 and the value you obtain when calculating the equation is the IRR, as shown below:
2. Replace the values in the equation
3. Use a financial calculator or do the calculations by hand, whichever is more comfortable for you
4. Offers results in %.
Clarification: The idea of setting this equation to zero is based on the assumption that the present value of your investment will remain unchanged until the end of the process.
Done! Now let's put all of the above into practice.
Example of calculating the internal rate of return
We understand that applying the IRR can be complicated if you're using it for the first time and aren't entirely sure how to calculate it to determine the return on an investment. Therefore, we're providing an example to help you better understand how to do it.
Imagine you want to invest in a real estate project that will last 4 years, for which you plan to dedicate approximately $40 million MXN, a figure of which you will not recover anything until the end, since the internal rate of return is based on compound interest where everything earned is reinvested.
In the first year of your investment project, you estimate that you will earn approximately MXN $10 million, in the second, approximately MXN $15 million, in the third, MXN $20 million, and in the fourth, MXN $25 million. In the formula, this data would be as follows:
Once you do the calculation based on these figures, it will result in 0.22, which when converted to a percentage It would be a 22%. So, we can say that the IRR in this example is 22%.
This number probably doesn't mean anything to you on its own, so you need to interpret it correctly to determine whether it's a profit or loss percentage. We'll explain that in more detail later.
What is a good IRR?
There is no perfect value for the internal rate of return, as it varies depending on the sector or industry in which you are investing. For example, In real estate, for an IRR to be considered good it must be in the range of 15% to 20%.
However, if you keep these three IRR results in mind, you'll always be able to make the right decisions and enjoy the best interest rate:
- Greater than zero: The project is expected to generate a positive return on investment and you can accept it because it will offer you benefits.
- Equal to zero: It means that by making an investment you will not obtain any losses or profits, so it is not worth focusing on that project.
- Less than zero: It shows that the project is not profitable, since the cash flows generated do not cover the minimum required rate of return. Therefore, it is best to abandon the investment to avoid losses.
Additionally, it's important to keep in mind that the higher the IRR, the greater the profitability of a project. If the rate is too low, the project doesn't meet the minimum profitability requirement and offers no benefit to you.
Use the IRR for all your investments
In the business world, metrics make the difference when making decisions because they clarify ideas and show concrete results that let you know whether you're on the right track or not. This is precisely the importance of calculating IRR.
At Proyectos 253, we want you to be part of our plans, so we recommend using the internal rate of return to successfully choose the one that's right for you. Contact us and let's talk about the real estate investment options available to us.
