What is IRR?
IRR (Internal Rate of Return) is the annualized rate of return an investment generates over its holding period. It's equivalent to the interest rate on a savings account, but works for irregular cash flows at varying times as well.
For rental properties, IRR reflects the three key performance drivers—operating cash flow, property appreciation, and financing—translated into periodic cash flows and distilled into a single annualized percentage.
This makes it possible to compare different properties on an apples-to-apples basis. However, the result is only as reliable as the growth assumptions embedded in the cash flow projections.
How IRR is Calculated
The Formula
IRR is the discount rate that makes the Net Present Value (NPV) of all cash flows equal to zero:
NPV = Σ (CFt / (1 + IRR)t) = 0
Where CFt = cash flow at time t
There's no closed-form solution. One could either calculate it numerically using Newton's method or use Excel's XIRR function .
Cash Flows at Investment
The initial outlay (negative cash flow) at time zero:
- Down payment — typically 20–25% of purchase price
- Closing costs — 2–5% of purchase price (title, legal, lender fees)
Cash Flows During Operations
Annual net cash flow = Rental income − Operating expenses − Debt service
- Gross rental income — subject to rent growth assumptions
- Vacancy allowance — percentage of gross income
- Operating expenses — property taxes, insurance, maintenance, management
- Debt service — principal + interest payments
Growth Rate Assumptions:
| Assumption | Bear | Base | Bull |
|---|---|---|---|
| Rent Growth | 1% | 2–3% | 4–5% |
| Expense Growth | 4% | 3% | 2% |
| Vacancy Rate | 10% | 5–8% | 3% |
Cash Flow at Sale
The terminal value (positive cash flow) at the end of the hold period:
- Sale price — based on appreciation assumption
- Less: Remaining mortgage balance
- Less: Selling costs — typically 6–8% (agent commissions, transfer taxes)
Appreciation Assumptions:
| Scenario | Annual Appreciation |
|---|---|
| Bear | 0–1% |
| Base | 2–3% |
| Bull | 4–5% |
IRR vs Other Metrics
Cap Rate and Cash on Cash Return are point-in-time metrics that evaluate year-one performance—useful for quick comparisons but blind to long-term growth. Equity Multiple captures total return over the hold period but ignores timing—a 2x return in 5 years is very different from 2x in 15 years. IRR bridges these gaps: it models the full investment lifecycle and discounts cash flows for time, making it the most comprehensive single metric for comparing investments with different timelines and cash flow patterns.
| Metric | Time Horizon | Time Value of Money | Best For |
|---|---|---|---|
| Cap Rate | Year 1 | No | Quick property comparison, market analysis |
| Cash on Cash | Year 1 | No | Understanding leveraged first-year returns |
| Equity Multiple | Full hold | No | Understanding total wealth creation |
| IRR | Full hold | Yes | Single percentage comparable to other investments |