30 Days of 3.0 – Day 22: Internal Rate of Return
Welcome to Day 22 in our “30 Days of 3.0” series. Yesterday we talked about how to look at the Time Value of Money with Net Present Value. Today, we’re going to talk about an indicator that builds on the NPV concept, called Internal Rate of Return, or IRR for short.
As we mentioned yesterday, Net Present Value is a way of showing future cash flows in today's dollars. Other inflation adjustments, like this one from Box Office Mojo, show you yesterday's money, today. NPV is like standing in today and looking at tomorrow's money, today.
IRR is *very* similar to NPV. In fact, it uses the NPV formula as a part of it's calculation. But where NPV is a relatively simple calculation, because you're plugging in the discount rate already, IRR is a repeating process (algorithm) that attempts to find the rate for that year that makes your NPV = 0.
There are a couple different ways to do this (for you math wizards out there): the bisecting method and the Newton-Rapshon method. The first is more error-prone; Excel and AdvancedREI both use the latter. But Excel's version will only cycle 20 times on a single set of returns. If it can't find the rate by then, it simply errors out. Our version keeps going until it finds the answer.
So let's take a look at real results from one of the properties in our system.
You can see here that the IRR doesn't hit the black until it's 3rd year (2017 in this case), so the investor should keep the property *at least* that long. The investment tops out on annualized returns in year 8 (2022 in this case), so if the investor isn't going to hang onto it forever, they should think about selling it then, before the returns go down again in 2023 and 2024.
The beauty of this indicator is that you don't have to be a financial genius to see the points I made in the last paragraph. If your investment strategy is targeting a > 10% return in a 7 year window, you can easily see whaich properties make the grade, and which ones don't.
And with that, we've wrapped up our breakdown of the new Returns section. Tomorrow, we dive into other user experience improvements as we move into the home stretch. I’ll see you then, and as always, I hope you have a fantastic day! :)