Understanding Internal Rate of Return When You Invest

Understanding what exactly internal rate of return means in the context of investing honestly has been very difficult for me. On its face it seems like a relatively easy concept – it’s the return that an investment provides. But it’s not that simple. And like any measurement, it is imperfect. It can even be misleading at times.

Compounding all of this is that internal rate of return is a very commonly used metric in the investing world. It’s very commonly used among businesses in determining what capital expenses are worthwhile for them.

But in the world of doctors investing, you are most likely to come across this metric when looking at real estate investments, specifically passive real estate deals.

These investments are popular, and for good reason most of the time. But this is even more reason that potential investors need a solid understanding of the internal rate of return metric.

So let’s dig in.

How does an investor calculate internal rate of return?

That’s it. Easy. Post over.

Well, I guess for those of you like me who have completely forgotten any sort of calculus, we can go more in depth. Because this clarifies about nothing!

The bottom line here is that this is the technical equation. But you can also just use the IRR function in Microsoft Excel. Which I recommend much more highly.

But just having the number does us very little good. We have to actually have an understanding of what the number, the internal rate of return, means.

What does internal rate of return measure?

Here are a couple more technical definitions of IRR:

The internal rate of return (IRR) is that it is the interest/return rate that causes the net present value to equal zero
The IRR for an investment is the percentage rate earned on each dollar invested for each period it is invested

In the equation above, the “0” on the left hand side of the equation represents the net present value (NPV) of the investment.

Thus, the equation really describes how to solve for NPV. But, in the case where you make NPV equal 0, you can solve for the return rate. And in that case, by definition, this return rate is the IRR.

Clear as mud yet?

Let’s take a step back and look at what NPV is

You may recall from this post examining the return on my medical education that the formula for net present value (NPV) is:

NPV = (Today’s value of expected future cash flows) – (Today’s value of invested cash)

Honestly, this is where I had major mental block in my understanding of IRR for a while. Because why would we want to arbitrarily make the NPV equal to zero? Isn’t an investment with a NPV of 0 a bad one?

What does this mean for IRR?

Well, the reason this is done in IRR is because it considers and somewhat measures time value of money (TVM). This a concept states that an amount of money will be worth more now than the same amount of money some time in the future (due to inflation and the fact that money compounding now is better than money compounding later). Thus, the future cash flow that results from an investment is discounted to its present value in the IRR equation.

So, IRR measures the return of an investment while weighting earlier returns as better than later returns (because money now is better than money later).

In the most basic terms, IRR is a measure of return on investment adding the variable of time to the mix.

An example of an IRR calculation

From Investopedia, imagine an investment in a real estate syndication like this where you initially invest $5,000. Then the future returns are:

Year 1 = $1,700
Year 2 = $1,900
Year 3 = $1,600
Year 4 = $1,500
Year 5 = $700

Using the above formula, our IRR is

$0 = (−$5,000) + $1,700 ÷ (1 + IRR)1 + $1,900 ÷ (1 + IRR)2 + $1,600 ÷ (1 + IRR)3 + $1,500 ÷ (1 + IRR)4 + $700 ÷ (1 + IRR)5

Or we can just use the IRR function on Excel. Either way we get:

IRR for our investment = 16.61%. In this case, the investment seems like a good one.

What are the weaknesses of IRR?

The biggest weakness of IRR is also a bit of its strength. And that is the fact that it includes time as a variable.

Baked into the equation is the notion that earlier returns are better than later returns. Thus, it is possible to have two investments that give the same absolute overall returns but different IRRs. This can happen if Investment A has better early returns and worse later returns while Investment B has steady returns each year.

Does this mean that IRR is a bad metric?

No, not necessarily. Remember, no measurement is perfect. Even net worth, the best measure of wealth in my opinion, does not do a perfect job of actually measuring wealth!

The ultimate strength or weakness of any metric is in our ability to understand it and apply it properly.

How to use our understanding of internal rate of return when investing

IRR should not really be used in isolation in my opinion.

Yes, it gives you a sense of how returns will be over time. But it doesn’t actually measure the overall return that you will get from an investment – because it is not designed to do that!

This is the biggest issue that I see especially when doctors evaluate potential passive real estate investments. They just look at IRR and use it as synonymous for overall returns. But it’s not.

So you need to ask the deal sponsor to break down the timing of returns and overall projected returns as well. This makes sure that the IRR is not misleadingly high just because there are good early returns. And if the sponsor won’t share these numbers, that’s a red flag!

And remember, all of these measurements for these deals are projected, not real. No return for any investment is real until the money is in your pocket, or bank account.

So also ask for IRR and return data for past deals that have gone full circle.

Why I don’t use IRR much

You can chalk this up to preference.

As I just said, IRR does a good job at measuring what it is supposed to measure. But it is imperfect in isolation to evaluate an investment.

As many of you know, I like to use cash-on-cash (CoC) return instead when evaluating my real estate deals. And here is an in depth guide of CoC calculations.

The main reasons I like to use this metric instead of IRR are:

CoC is simpler and more straightforward to calculate and understand,
In our real estate deals, we look for consistent returns, thus making time a less important variable in the evaluation of a deal,
CoC gives a real picture of the actual absolute projected or real returns on the money that we invest in a deal

This works in our case largely because of the second point above. We thus far invest in small multifamily properties that don’t need complete rehab. Thus, cash flow stay relatively consistent under our conservative assumptions.

However, this is not necessarily the case with larger deals, especially value add deals where a large chunk of money is needed up front to renovate properties before cash flow increases. In this case, IRR does provide a helpful picture…but again you still need other data points!

The final word on IRR

As you invest more and more, you will likely run into IRR. And having a good understanding of what internal rate of return is good at measuring…and bad at measuring is very important.

In basic terms, it measures cash flow weighted by time, with earlier returns being better.

It’s a good metric but, like most, needs other data for the right context.

And I hope this post helps remove IRR from the “black box” of investing terms that don’t make sense!

Here are some other guides to help you understand how to measure your financial wealth:

What do you think? Do you understand IRR? What makes sense and what doesn’t? Do you often use this metric to evaluate investments? Let me know in the comments below!