Below is a mathematical formula for calculating the Internal Rate of Return:

Much in the same way that “Fissure an oblong orb from a domestic fowl” is a long and complicated way of saying “Crack an egg,” the formula for IRR is a complicated way of writing a straightforward idea, the eventual annual rate of return for invested capital over a full investment cycle. 

The details in this blog post will not be so messy.

There are a great number of resources available that explain the fine details of the Internal Rate of Return, one of which is the source for the above equation. This blog post will bring this knotty actuarial abstraction down to the ground level. As such, there may be some technical or mathematical nuances that are not included here, but this simplification is by design. Once you understand the basic purpose and operation of the Internal Rate of Return, it is easier to then go back and delve into more complicated ways to construct and utilize the metric.

The Internal Rate of Return is commonly used to project the profitability of an investment. Knowing this, and knowing that you cannot predict the future, you should be aware that the IRR is not a fixed absolute, and it is dependent on the information that you feed into it. You can use data from the past, change some inputs based on your plans for the property, and project a future IRR.

The IRR is measured over a specified period of time, the hold period. You can calculate the IRR based on your ideal investment window, with the period represented by the year. The IRR is a yearly rate, so the number you get will reflect the average growth for those seven years.

You could use any interval of time for the period when calculating the IRR. If you were modeling the IRR over a short hold period, say one year or even a month, you could use days or months for your period.

The Internal Rate of Return tries to answer this question: What is my actual annualized rate of return taking into consideration how much capital I invest compared to all the distributions/dividends I receive, and the return of and appreciation of my initial investment?

Net Present Value (NPV)

While we can’t predict the future, we can control for things that would skew our predictions. For one, a dollar today is worth more than a dollar a year from now. That’s one of the underlying assumptions used when calculating the IRR, and that assumption plays a large part in another term that can be used to help calculate the IRR, the Net Present Value (NPV).

Here is a simplified way to get the NPV:

  • Start with the total capital outlay, and make that negative
  • Calculate all future cash flows for each period by subtracting all of the cash flowing out from all of the cash flowing into the investment
    • Cash flow includes distributions, capital calls, refinancing, and sales proceeds
    • The cash flow for a given period can be negative in cases of renovations or other costly circumstances that affect your bottom line
  • Include the price you’ll sell it for at the end of the period in question
  • Adjust these prices by a discount rate to control for the different factors that lower the value of money in the future
    • Interest rates
    • Cost of debt
    • Inflation
    • Money that could have been earned in an alternative investment
  • Add the (negative) purchase price to the adjusted values of each year’s cash flow and the final year’s sale price. The sum of these adjusted values is your NPV.

The adjustments and discount rate are key to thinking about the Net Present Value. This discount rate stands in for all of the factors that make money in the future less valuable than money at the present. You can adjust for what you would have made in an alternative investment. You can (and should) also adjust for the cost of debt, equity and taxes. All of these considerations can be part of the discount rate number, and it can vary based on what you choose to include. Commonly, the NPV is calculated with a discount rate based on the cost of capital called the Weighted Average Cost of Capital. Whatever you choose to include in your discount rate, you will end up with a percentage that represents the rate at which the value of a fixed amount of money will decrease in future years.

Here’s a quick example of how a discount rate works year to year.

If you make $100 from an investment every year, you need to adjust the future $100 income into today’s dollars. To do this, you multiply that future cash flow by 1 minus the discount rate to turn the first year’s dollars into current-value dollars. It gets trickier for the following years, so here’s a quick example:

Let’s look at three years of those $100 returns, and let’s put the discount rate at 10%.

Year one is easy enough to do in your head: 1 minus 10% is 90%. So the first year, you’ll get $90 in today’s dollars.

Year two? You need to square that 90%, which comes out to 81%. So you’ll get 81 dollars in today’s dollars.

Year three, you’ll cube that 90%, and you’ve got 72.9%. You’ll get $72.90 in today’s dollars.

Think about it: Your year three return could be $200, but in today’s dollars, it would be $145.8 in today’s dollars—just under two thirds of that amount.

To get the NPV for the investment, you need to account for the initial cost(s) of the investment, and you need to account for the final sale of the investment, which we illustrate below.

The IRR calculation comprises doing these steps to account for the value of your money in each year of the investment. Now that we have broken down what the discount rate and periods do each year, let’s combine this information and step through an entire sequence.

IRR and NPV in Action

We’re venturing slightly outside “easily-solvable-with-an-abacus” territory.

Let’s say you have bought a $100,000 investment property. You are holding it for three years. Let’s make the discount rate 15% this time (so you’ll be multiplying by 85%). After three years, you’ll sell the property for $150,000. Year one returns will be $15,000, year two will be $10,000, and year three will be $18,000.

I’ll start with getting the discount for each year, so it’ll be .85 for the first year, (.85)² for the second year, and (.85)³ for the third year. Year one stays at .85, year two comes to .7225, and year three is .614125 for the adjusted discount.

Year one returns: $15,000 * .85 = $12,750

Year two returns: $10,000 * (.85)² = $7,225

Year three returns: $18,000 * (.85)³ = $11,054.25

So far, you project that you’ll make $31,029.25 on this property. But you bought it at $100,000, so you’re still in the hole to the tune of $68,970.75. Thankfully, you plan on selling the property for $150,000 at the end of year three.

Year three sale: $150,000 * (.85)³ = $92,118.75

From here, you just add up your adjusted returns and your adjusted sale price, then you subtract the purchase cost. You get $23,147.75. That’s the NPV, the Net Present Value of your investment at the end of the cycle.

How do you turn this into an IRR? Can you simply divide by the number of years, which in this case is three, and then divide by the initial investment, which is $100,000? Unfortunately, it’s a derivative, and it’s not that simple.  

Formally, to get the IRR, you set the NPV to zero, and you solve for the rate. In the NPV calculation, the rate was 15%, but we’re going to set it to (and solve for) X in this case. We’re getting $23,147.75 when the rate is 15%, so we know that the rate has to be higher than 15%. But, because the effect of the rate changes each year, it is very difficult to figure out by hand outside of a trial-and-error process of plugging in different rates and finding out which one will make the NPV closest to zero. Fortunately, spreadsheets like Excel and Google Sheets have a built-in IRR function that will generate the value for you.

Like any financial metric, the IRR is just a tool. It can be used in different ways by different people, and, like the cap-rates we discuss in another blog post, an IRR means different things depending on the perspective of the investor, what their roles are, and what they are trying to do.

The most common use for the IRR metric is as a comparative metric used to weigh one investment versus another.

It’s also important to understand that a pro forma IRR can be manipulated in several different ways by adjusting the multiples variables and inputs. The most common way to manipulate an IRR to show outsized returns that may not be realistic is to change the value increase at the termination of an investment. Typically the largest tranche of cash flow is from the sale of an investment, and by assuming a frothy sales price an IRR can be higher than what might be conservative and realistic.

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I hope everyone is continuing to stay happy, healthy, and hopefully you’re making some awesome investments and some really smart decisions. You’re growing your net worth. You’re creating some passive income. You’re taking massive action. You’re doing all of those things that you’ve been watching videos and you’re supposed to do.

Making smart, rational decisions is important, but today, I want to talk about emotions when it comes to investing. 

Now, you may have heard that you really don’t want to use emotions to guide your investing. That’s absolutely true. If you’re using your emotions to guide your investing, you’re not using the frontal lobes in your brain that dictate higher thinking in logic. You need to be as emotionless as possible and really be able to look from a clean slate. If you can’t remove yourself from the situation to kind of see from a 360000 foot level of the entire situation and not from the perspective of your own biases your own emotions and your own just personal feelings about something, you’re not going to be able to make a truly unbiased empirical logical decision.

A recent episode of the Freakonomics podcast hits on exactly this emotional perspective. Maria Konnikova starts with the context of a poker game and argues persuasively about the importance of detachment and how, when you “learn to see yourself from an external perspective,” you can “spot the errors that you make in your decision process.” Emotions can be a significant barrier to this detached frame of mind:  “We don’t notice that we’re making a decision while angry because we don’t stop to assess, ‘Oh, I’m angry. What’s making me angry?’ We just don’t have that sort of internal conversation.” Konnikova links this essential poker insight to professional, personal, and social success. Whether you’ve bet too much on a bad hand or you’re chasing a bad investment, taking a deliberate step to examine the emotions and motivations behind your decisions can help you seize great opportunities and recover from unfortunate situations outside of your control.

If you allow your emotions such as fear, greed, or excitement to seep in, your entire brain is going to be focused on dealing with those emotions, and you’re not going to be able to think clearly. Most likely, you’re going to make a decision that isn’t necessarily the best. Now this applies to any aspect in life, but when you’re talking about putting your hard earned money on the line, it’s even more important. 

If you watch Star Trek, this is exactly what the Vulcans do, and their entire philosophy is built on this rationality. They take logic and they put it up on a pedestal, and they try to purge themselves of all emotion entirely and only use that logic to guide all of their decisions, all of their actions, and all of their thought. Now I don’t think that’s the right thing to do. Emotion does have a piece to play in everyone’s life, but you have to be able to control your emotions. Like I said you have to be able to take a step back and remove yourself from a situation. You’ve probably heard the saying “you can’t see the forest for the trees.” If you’re looking at a tree, you won’t get a full view of the forest. You’re not going to be able to have a perspective on what’s actually occurring.

It takes practice, but by taking a deep breath and removing yourself, you can have much more clarity of the actual situation that’s surrounding you. You’ll be able to process what’s going on and take the correct action required to achieve whatever you’re trying to accomplish. 

So, where can you use emotion though in investing, and how can you use it as a tool? You can really only do this once you’ve mastered the technique of being able to control your emotions. Once you are able to turn your emotions off, you will be able to dictate what’s going on and have a clear understanding, but you can use your emotions almost like a sensor, turning the spigot of your emotions on you can start to build empathy and try to understand the situation from others’ point of view. This understanding of others, it should be noted, is hard to acquire if you are caught up in your own emotions.

For example, let’s say you’re looking at an apartment building. You’ve turned your emotions off when you’re analyzing. You know the location, the financial analysis, the demographics—you’re doing everything that you do when you look at a property rationally, using one hundred percent your frontal lobes. You’re just trying to analyze it based on empirical evidence and research, but residents and potential renters don’t rent based on logic, reason, or with a spreadsheet. They’re using their emotions. By tactically turning your emotional spigot on, you’ll be able to identify the things that matter to residents and potential renters.

What kind of feeling do you get when you walk on a property? Do you have any emotional connection? Do you feel safe? You do feel at home? Maybe you feel community. Well, that could be a good indication that a resident or potential resident may have that same connection. Then you can turn it off. Take it back. Use it as another piece of evidence. 

Now, you have to be careful with this, and again, it’s all about practice and using it at the right time and the right level. I’m not saying that you purge emotion from yourself entirely. With family and friends, emotions play an important part in all of our lives. They are a part of the human experience. But you should be able to control and regulate your emotions. Turn them on and off at the appropriate times. You’ll be able to achieve much more success, make clear decisions, and I guarantee your investment career will accelerate faster. You’ll see better results. 

For example if you’re looking at several different investment opportunities it’s easy to allow emotions to creep in. Well I like this part of town. I like this market. That’s where I. That’s where I grew up. My father’s from that neighborhood. Sure, it would be great to tell Dad, “I’m buying a property where you used to live.” Well, if that investment is going to lose money, then the warm emotions of nostalgia can’t really help you.

Your investors probably won’t have that same nostalgic emotional connection. The next buyer doesn’t have that emotional connection, and your residents may not have that emotional connection. 

By being able to regulate control and understand how you’re feeling and being able to compartmentalize it, you can look at multiple opportunities and make an actual specific reasonable decision based on logic and reason not emotion. So again, emotion plays a key part in all of our lives. It’s a part of the human experience, and you have to use it as a tool. You have to be able to control your emotions, and if you do that, I guarantee you’re going to see a lot of success.

We can even take it a step further. Let’s say you make all these logical decisions, and you develop the emotional control that allows you to see from the perspective of your residents and your investors. You take special care to cultivate this detachment and discipline. You still need to keep in mind that you’re never going to be completely separate from your emotions. Think about it: All of your decisions are appropriately logical, but what is it that is motivating that logic? What is it that has driven you to this career in the first place? That passion, that motivation, is incredibly powerful, but the minute you think that you’re above your emotions, that’s when they can start to creep in and overwhelm your decisions. Part of emotional control is realizing that there is always an emotional part of your brain that motivates you, but once you identify that, you can use it to your advantage, to propel you forward without holding you back.

All right. This interesting. Do you disagree or you say this is B.S.? You know you have to use emotion. You know Star Trek sucks? That’s fine. Happy to have the conversation. Comment below.

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