How to Calculate IRR for a Rental Property

What IRR measures

IRR is the annual discount rate at which the present value of everything a deal pays you equals the present value of everything you put in. Put plainly, it is the compound annual rate your invested cash earned over the life of the investment, counting when each payment arrived.

Two properties can return the same total dollars and have very different IRRs. The one that pays you earlier wins, because you could have reinvested that money. That is the whole reason to prefer IRR over a simple total-return percentage when holds are longer than a year or two.

IRR compared with cash-on-cash, ROI and cap rate

Each metric answers a different question, and none replaces the others. The table shows what each one counts, what it ignores and what it is for.

The practical order is the order of the decision. Cap rate and cash-on-cash screen the deal and set the offer. IRR decides between deals that both pass, and between holding and selling once you own one.

A worked example: a five-year hold

Take a $250,000 single-family rental bought with 25% down and $6,000 in closing costs, so $68,500 of cash invested. The $187,500 loan at 6.75% costs $1,216 a month.

Rent starts at $2,300 and grows 3% a year; operating expenses start at 38% of rent and grow 2% a year. The property appreciates 3% a year and is sold after year five with 7% selling costs.

1. 1

   Lay out one cash flow per year

   Rent less operating expenses less the $14,592 of annual debt service. Year one is thin; the 3% rent growth against a fixed mortgage widens it every year.
2. 2

   Work out the net sale proceeds

   Sale price after five years of 3% growth is $289,819. Subtract 7% selling costs ($20,287) and the remaining loan balance ($176,017). Net proceeds: $93,514.
3. 3

   Add the proceeds to the final year

   Year five becomes $5,119 of cash flow plus $93,514 from the sale, $98,633 in total.
4. 4

   Solve for the rate

   The rate that discounts those six numbers back to zero is the IRR. In a spreadsheet: =IRR(range) with the investment as a negative first cell.

The projections tab in a property analysis builds the same table, year by year, with the loan balance amortized and the sale modeled, and prints the IRR if sold in each year so you can see the curve rather than one point on it.

Example uses public listing data for illustration. See disclaimer.

What moves the IRR

Three inputs dominate: how long you hold, what rents do, and how much of your cash comes back early. Running the example again with one change at a time shows the size of each.

The loan matters too. Equity builds slowly at first and faster later as more of each payment goes to principal, so the paydown component of the sale proceeds grows with every year you hold.

Example uses public listing data for illustration. See disclaimer.

Where IRR misleads

IRR is the most complete of the common return metrics and still has blind spots. Knowing them keeps it from being the only number you look at.

• It assumes reinvestment at the IRR. A 20% IRR assumes every dollar of cash flow was reinvested at 20%, which rarely happens. Very high IRRs on short holds overstate what you actually compounded.
• It hides scale. A 14% IRR on $20,000 is less money than a 10% IRR on $200,000. Read IRR beside total profit.
• It depends on the sale assumption. Most of the terminal cash flow is the sale. Change the appreciation rate from 3% to 1% and the example's IRR falls by several points. Test the downside.
• It is pre-tax unless you make it otherwise. Depreciation and capital gains change the real answer. Compare deals pre-tax; decide sales after-tax.

Used with those limits in mind, IRR is the right tool for two decisions: which of two acceptable deals to buy, and when to sell the one you own.