IRR vs ROI in Real Estate Investing

Both IRR (internal rate of return) and ROI (return on investment) are critical metrics for real estate investors.

Sometimes investors mistakenly use the terms interchangeably, but there are some key differences between the two.

In short, IRR is used to estimate the annual rate of growth, while ROI is used for the total return on the investment, no matter the time length.


Similarities Between IRR and ROI: An Example of a Single-Family Rental

With “return” in the name, there are naturally going to be similarities between these two metrics. Both look at the returns on your investment to determine overall profitability.

Let’s say you purchased a single-family rental in cash for $250,000. It rents out for $2500/month. To keep things simple, we’re going to eliminate all of the other phantom costs associated with real estate (although you should always keep those in mind).

At the end of one year, your ROI is going to be 12%. You invested $250,000 and earned $30,000. That’s 12%.

Your IRR is going to be -88% since you’re still technically down 88% until you’ve cashed out. (Notice, though, that if you did cash out for $250k, your IRR would be the same as your ROI).

But let’s say your tenant moves out because she found a new job halfway across the country, and you have trouble finding a new tenant for the next four months. You find another tenant for $2500/month, but you lost four months of rental income.

Meanwhile, however, property values have skyrocketed. Three houses in your neighborhood that were nearly identical to yours sold for $300,000. Because property values are high and you disliked having to search for new tenants, you’ve decided to sell the property for $300,000 to a fellow real estate investor at the end of two years.

To quickly review the numbers, you earned $50,000 total in rental income ($30k the first year and $20k the next) and $50k in equity when you cashed out, for a total gain of $100,000.

Your internal rate of return, an annual figure, is 19.296%, while your total ROI is 40%.

In short, IRR is very similar to an annualized ROI.


Differences Between IRR and ROI: Time-Value of Money

IRR is a more complicated formula than ROI. Before Excel formulas became mainstream, few investors took the time to calculate the IRR of a real estate investment.

However, IRR takes into account the time value of money while ROI doesn’t. What does that mean, exactly?

Because it’s an annualized figure, you can use IRR to more accurately track the profitability of certain investments every year. A 40% gain sounds great over two years, but what if the total length of the investment was 40 years? A 40% ROI wouldn’t have even kept pace with inflation. Your IRR, meanwhile, would be more like 1% — a figure that would probably steer you away from the deal.


Conclusion: Differences Between IRR and ROI in Real Estate Investing

It’s important to take a comprehensive approach when you’re analyzing an investment. Don’t just look at one or two metrics when you’re trying to find out whether or not you want to invest; try to look at the whole picture.

IRR and ROI, though, are two metrics that are nearly essential for many real estate investors. They’re both used to track the profitability of an investment.

The main difference is that IRR is an annualized figure that takes into account the time value of money while ROI looks at the overall return on your investment, no matter the time length.



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