When it comes to real estate investing, you can use many different measures to evaluate a potential property. Two popular measures are return on investment (ROI) and internal rate of return (IRR). Both ROI and IRR can help determine whether or not a particular property is a good investment. However, there are also some critical differences between the two measures that you should be aware of.
ROI vs. IRR: The Basics
At its simplest, ROI measures how much profit you make on an investment. To calculate ROI, you take the amount of money that you make on the investment (i.e., your “return”) and divide it by the amount of money that you put into the investment (i.e., your “investment”). For example, if you invest $100,000 in a property that generates $120,000 annual income, your ROI would be 20% ($120,000/$100,000).
IRR is a bit more complicated than ROI. IRR measures the “yield” or “return” on investment over time. To calculate IRR, you need to consider the initial amount invested and all cash flows generated by the investment over time. In other words, IRR considers both the positive (i.e., money made) and negative (i.e., money spent) cash flows associated with an investment.
The Key Difference Between ROI and IRR
One key difference between ROI and IRR is that ROI only looks at a single point in time (i.e., when the investment is sold), while IRR looks at cash flows over the entire life of the investment. IRR gives you a more accurate picture of how an investment performs over time.
Another key difference is how ROI and IRR are affected by the leverage (i.e., borrowed money). If an investment is made with borrowed money, as is often the case with real estate investing then the calculated ROI will be higher than it would be if no leverage were used because leverage amplifies returns. However, IRR takes into account all cash flows associated with an investment, including interest payments on any borrowings used to finance the investment. It will not be affected by leverage in the same way as ROI.
Both ROI and IRR can be helpful measures for evaluating potential real estate investments. However, it’s essential to understand that each has strengths and weaknesses. ROI is a simple measure that only looks at a single point in time, while IRR considers cash flows over an investment’s entire life. Additionally, ROI will be higher than IRR when leverage is used to finance an investment because interest payments are not considered when calculating ROI. Ultimately, which measure you use will depend on your personal preferences and goals as an investor.