When it comes to investing in real estate, there is a myriad of ways to gauge your investment’s performance or potential performance. Of those ways, internal rate of return (IRR) and return on investment (ROI) are two of the most common. Yet, while they are complementary, the two metrics are indeed different. If you’re considering breaking into real estate investment, keep reading for what you need to know about IRR versus ROI.
What is IRR?
IRR is commonly used by investment property investors to assess the prospective profitability of a venture or to calculate the performance of a done deal, expressed as a percentage. It’s a way to compare the potential value of a real estate investment as if it were valued in today’s dollar. By figuring out what an investment will be worth, what it would bring today, and lining that up against how much you invested, you can get a good idea of your investment’s risk.
Why is IRR Used by Real Estate Investors?
When investors are figuring out the IRR for an investment, they are approximating the rate of return. But not before considering the projected cash flow and the time value of said cash. If you have multiple investment opportunities, you can calculate the IRR for each one. The idea is that the option with the highest IRR would likely be your best bet. In simple terms, figuring out the IRR for each potential investment shows what the project would be worth today. In turn, that helps you understand the investment’s likely future worth.
What is ROI?
In real estate, the metric called return on investment helps investors gauge whether they should purchase a property. The tool also helps you conduct apple-to-apple comparisons of multiple investment candidates. Based on such comparisons, ROI permits investors to predict realized profitability as a percentage of the cost.
How is ROI Calculated in Real Estate?
Generally, an investment’s ROI is tantamount to the investment’s gain minus the cost, divided by the cost. That’s the formula. At length, however, there are variables that will affect the ROI. Those include the amount of money borrowed to make the investment, repair and maintenance costs, and some mortgage terms.
What are the Key Differences Between IRR and ROI?
Some people use the terms interchangeably, but while they’re similar, there are distinct differences.
Basically, the internal rate of return is a specific method for calculating investment returns. On the other hand, ROI is a broader term that encapsulates all the ways of figuring investment returns.
Another way to explain the differences is, IRR figures the annualized growth rate while factoring in the time value of money. On the flip side, ROI assesses the growth rate from the investment’s start to finish but doesn’t account for the time at which income is received.
Also, while IRR calculates the annualized return, ROI gives you a snapshot of the investment return from beginning to end. Further, while IRR considers the amount and timing of returns, ROI doesn’t.
Because ROI is easier to calculate, that metric is more widely used than IRR. While over the course of a year the two calculations may appear to be comparable, their distinctions will show when compared over longer periods.
Now that you know all about IRR versus ROI, you’ve become familiarized with two of the most widely used metrics in real estate investing. You need this knowledge so that you can calculate the likely profitability of your investments. If you want to educate yourself further on investing in real estate, we suggest that you contact Yieldstreet, a platform that’s dedicated to producing secondary income streams for investors.