Internal Rate of Return (IRR) Made Easy
What Is IRR?
The Internal Rate of Return, or IRR, is one of the most important metrics in real estate investment finance. It tells you the average annual return an investor earns over the life of a project, based on the timing and size of the cash flows. Unlike simply looking at profit or total return, IRR considers the Time Value of Money — the idea that a dollar today is worth more than a dollar received years from now (because you can invest money today and earn a return with it). In real estate, where cash flows happen over time, IRR helps you evaluate how efficiently a deal generates return.
(Bonus: A technical question interviewers love to ask is would you rather buy a property for $100,000 less or sell it for $100,000 more. The answer is you would rather buy it for $100,000 less because this has a larger positive effect on the IRR, since earlier cash flows are weighted more heavily in the IRR calculation, due to the Time Value of Money.)
How to Calculate IRR
Use the IRR() function in Excel and select the cash flows. If you have specific dates, use the XIRR() function as this will give you a more accurate result since it calculates irregular cash flow periods (like months with different days), IRR() assumes all cash flows occur in equal intervals. For both functions, make sure the first value in the series of cash flows is a negative, otherwise the formulas won’t work.
How to Interpret the IRR You Calculated
The whole idea behind IRR is simple — you calculate the IRR based on the expected cash flows in an investment (we’ll call this the Project IRR) to perform and compare that number to your Required Rate of Return (also called Targeted Rate of Return or Opportunity Cost), this number represents would you minimum you want to make on a deal, based on the risks and effort involved compared to other, similar deals. There are 3 possible outcomes:
If your IRR is greater than the Required Rate of Return (Project IRR > Required IRR), then it’s a good deal, because you are making more than you are targeting
If your IRR is less than the Required Rate of Return (Project IRR < Required IRR), then it’s a bad deal, because you are making less than you are targeting
If your IRR is equal to the Required Rate of Return (Project IRR = Required IRR), then you are indifferent about doing the deal, because the deal offers the same returns as other, similar investments
Example
Below we have an example investment. We purchase the property for $4,500,000 in Year 0, hold it for 5 years collecting the cash flow, and then sell the property at the ending of Year 5. For this investment, we are targeting a 7.00% return. Do we want to do this deal based on the 11.60% IRR we are expected to earn? Absolutely.
Key Takeaways
Understanding IRR is a big step toward thinking like an investor. It helps you evaluate not just how much an investment returns, but how efficiently it returns it over time — a key factor in real estate deals where timing matters just as much as total profit.
If you’re still unsure how to apply IRR in your own modeling or assignments, that’s completely normal. The best way to lock it in is by walking through it with someone who’s done it before.
Schedule a 1-on-1 session and get hands-on support building confidence with IRR and the full modeling process.