Want to know if a project is good enough to invest in? The internal rate of return is exactly what you need, as it will get you out of a bind whenever you need objective data to make a decision.
And that's because This metric is especially useful if you're looking to invest in real estate. and you need to evaluate the profitability of a real estate development, to take firm steps based on data.
However, the IRR isn't exclusive to this sector, so you can use it to calculate the profitability of different projects. If you don't know 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 (IRR) is a formula that allows you to calculate the annual profitability of a project. In other words, It measures the viability of an investment to determine 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 to determine the expected growth rate for a specific investment over a period of one year or more.
Hence It works like a discount rate, In other words, it allows you to calculate the value of the income you will obtain at the end of the investment, taking the current value of money as a reference.
This is very important because It helps you choose those projects that are truly profitable for you.
What is the purpose of calculating the Internal Rate of Return?
The Internal Rate of Return is used to choose projects with growth potential that provide benefits over time and to discard those that produce losses of time or money.
In general, this excellent metric can be useful for:
- Choose from several financing options, those that truly 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.
- To determine the financial viability of a long-term 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 bit daunting at first glance, it's really not that complicated; you just need to understand each of its variables and everything will become much simpler when using it:
Where:
- VAN: It is the Net Present Value or Net Present Value
- t: constitutes the period of time
- n: total number of periods
- Ft: net cash flow during the time period
- I0: total cost of the initial investment
- IRR: represents the Internal Rate of Return.
The formula we shared earlier is the original one. As you can see, 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 get 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 to solve it in an Excel spreadsheet or by hand, as it is not that difficult.
You just have to follow the order of the equation and give priority to the operations enclosed in parentheses and use a standard calculator to perform each of your operations.
How to calculate the IRR?
To calculate the Internal Rate of Return (IRR), it's best to proceed step by step to avoid confusion 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 that of 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 convenient for you.
4. It provides the results in %.
Clarification: The idea of setting this equation equal to zero is based on the assumption that the present value of your investment will remain unchanged until the end of the process.
Okay! Now let's put everything we've discussed into practice.
Example of calculating the internal rate of return
We understand that applying the IRR can be complicated if it's your first time using it and you're not yet entirely clear on how it's calculated to determine the return on an investment. Therefore, we'll provide 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 about $40 million MXN, a figure from 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 obtain approximately 1.4T10 million MXN, in the second year approximately 1.4T15 million MXN, in the third year 1.4T20 million MXN, and in the fourth year 1.4T25 million MXN. In the formula, this data would be represented 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%. Therefore, we can say that the IRR in this example is 22%.
This number probably won't tell you much on its own, so you need to interpret it correctly to determine whether it represents a percentage of profit or loss. We'll explain that in detail below.
What is a good IRR?
There is no single perfect value for the internal rate of return, as it varies depending on the sector or industry in which you invest. 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 3 IRR results in mind, you can always make the right decisions and enjoy the best interest rate:
- Greater than zero: The project is estimated to generate a positive return on investment, and you can accept it because it will offer you benefits.
- Equal to zero: This means that by making an investment you will neither lose nor gain, so it is not worth focusing on that project.
- Less than zero: This demonstrates that the project is not profitable, as the resulting cash flows fail to cover the minimum required rate of return. Therefore, it is best to abandon the investment to avoid losses.
Furthermore, it is important to keep in mind that the higher the IRR, the greater the profitability of a project, and if the rate is very low, it means that the project does not meet the minimum required profitability and offers no benefit to you.
Use the IRR for all your investments
In the business world, metrics make all the difference when making decisions because they clarify ideas and show concrete results that let you know if you're on the right track. This is precisely the importance of calculating the IRR.
At Projects 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 chat about the real estate investment options we have available.
