IRR (Internal Rate of Return)
IRR is the annualized return that makes the net present value of all cash flows equal to zero. In plain English: it is the discount rate at which what you put in equals what you get back, when both are expressed in today's dollars. It is the single most honest comparison metric for a leveraged real estate hold because it accounts for the timing of every dollar in and out.
Cash-on-cash return tells you your annual yield. Cap rate ignores financing. IRR captures all of it — upfront investment, annual cash flows, and the lump-sum equity at exit — and produces one annualized number.
When IRR matters
| Metric | What it measures | Financing included | Time value of money | Exit equity included |
|---|---|---|---|---|
| Cap rate | Property income yield | No | No | No |
| Cash-on-cash | Annual cash yield on invested capital | Yes | No | No |
| IRR | True annualized return on all cash flows | Yes | Yes | Yes |
Cap rate is a property metric. Cash-on-cash is an annual yield. IRR is the total return metric for a full investment horizon.
The formula (conceptually)
IRR solves for the rate r that satisfies:
Where CF₀ is the initial investment (negative), CF₁ through CFₙ are periodic cash flows, and CFₙ includes the net sale or refinance proceeds. There is no closed-form solution — IRR is calculated iteratively (Excel's IRR() function, a financial calculator, or a tool like Temelios).
Worked example
A $160,000 rental property with 25% down ($40,000 + $3,500 closing = $43,500 total invested). Held 5 years, then sold.
Annual cash flows during the hold:
| Year | Cash flow | Notes |
|---|---|---|
| 0 | − $43,500 | Initial investment |
| 1–4 | + $1,960/yr | Annual cash flow from operations |
| 5 (ops) | + $1,960 | Operations in year 5 |
| 5 (exit) | + $57,600 | Net equity after selling costs |
Exit calculation at Year 5 (3% annual appreciation):
| Item | Amount |
|---|---|
| Estimated sale price ($160K × 1.03⁵) | $185,500 |
| Selling costs (6%) | − $11,130 |
| Loan balance remaining | − $116,770 |
| Net equity at exit | $57,600 |
Combined Year 5 cash flow: $1,960 + $57,600 = $59,560
Cash flow stream:
| Period | Cash flow |
|---|---|
| Year 0 | − $43,500 |
| Year 1 | + $1,960 |
| Year 2 | + $1,960 |
| Year 3 | + $1,960 |
| Year 4 | + $1,960 |
| Year 5 | + $59,560 |
IRR ≈ 10.3%
What the number tells you
| IRR range | General interpretation |
|---|---|
| Below 8% | May not justify illiquidity vs. risk-free alternatives |
| 8–12% | Reasonable for stable buy-and-hold with modest appreciation |
| 12–18% | Strong; often requires meaningful value-add or appreciation |
| Above 18% | Excellent; verify assumptions aren't inflated |
These are orientation ranges, not universal thresholds. Compare IRR against your alternatives: a REIT, stock market index, or short-term bond. If the real estate IRR after full expense and realistic exit assumptions does not beat your next-best option by enough to compensate for illiquidity and management, it is worth asking why you are doing the deal.
How appreciation sensitivity changes IRR
The 5-year IRR for this property at different appreciation rates:
| Annual appreciation | Exit price | Net equity | IRR |
|---|---|---|---|
| 0% | $160,000 | $36,100 | 3.1% |
| 1% | $168,200 | $44,700 | 5.6% |
| 2% | $176,600 | $53,400 | 8.0% |
| 3% | $185,500 | $57,600 | 10.3% |
| 4% | $194,700 | $66,200 | 12.6% |
This illustrates a critical point: IRR is highly sensitive to the exit assumption. At 0% appreciation over 5 years, the IRR is 3.1% — well below inflation. At 4% appreciation, it is 12.6%. This is why you should model IRR at both your base case and a flat-market scenario before committing.
Common mistakes
1. Only modeling IRR at the optimistic appreciation assumption. IRR is often presented to justify a deal. Always run the flat-appreciation (or slightly negative) case. If the deal only works at 4% appreciation, you are counting on market growth, not investment quality.
2. Comparing IRR across different hold periods without context. A 15% IRR over 2 years is a different animal than 15% IRR over 10 years. The reinvestment assumption matters — that 2-year deal assumes you can redeploy capital at a similar rate.
3. Treating IRR as a standalone answer. IRR captures total return but obscures cash yield. A deal with 14% IRR and negative cash flow for 3 years may be unsuitable for an investor who needs current income.
4. Not including all cash flows. Forgetting capital improvement costs, lease-up periods, or refinance proceeds produces an IRR that does not reflect reality.
Frequently asked questions
What is a good IRR for real estate? Varies by strategy and market. Buy-and-hold investors in competitive markets often accept 8–12%. Value-add and BRRRR investors typically target 12–18%. Ground-up development may target 18–25%+ to compensate for higher risk. Compare against your alternatives and risk tolerance.
How is IRR different from ROI? ROI (return on investment) is total dollar return divided by total invested — it does not account for time. A 40% ROI over 8 years is worse than a 40% ROI over 3 years. IRR converts total return into an annualized rate, making time-period comparisons valid.
Does IRR include tax benefits? Standard pre-tax IRR does not include depreciation tax benefits. After-tax IRR is more accurate but requires knowing your tax situation. For comparison purposes, be consistent — use pre-tax everywhere or after-tax everywhere.
Can IRR be calculated before the hold period ends? You can calculate projected IRR using estimated future cash flows and an assumed exit value — which is what all underwriting does. The actual IRR is only known when the deal is fully exited.
IRR is an analytical projection, not a guarantee of returns. Actual returns depend on market conditions, execution, and timing. This is not investment advice.