XIRR vs IRR: Learn The Difference!
There are many different financial metrics that business owners need to be aware of. One of the most important is the Internal Rate of Return (“IRR”). This metric measures the return on an investment or project. However, there are different types of IRR. This blog post will discuss XIRR vs IRR, and the differences between Extended Internal Rate of Return (XIRR), and Internal Rate of Return.
If you are in the commercial real estate business, understanding the difference between XIRR vs IRR is vital. XIRR should be the go-to metric rather than IRR. XIRR is a more accurate return measure because it considers the timing of cash flows and considers potentially irregular cash flows.
Continue reading this article to understand the concepts that will help you make better commercial real estate business decisions in the long run.
Table of Contents
What is Return?
Return is a profitability metric that evaluates the overall performance of an investment or project. Returns are measured in absolute terms or relative terms.
Absolute return measures the losses or gains made on an investment or project over time. Relative return measures the performance of an investment or project with other investments or projects.
There are many different returns, such as total, net, and risk-adjusted returns.
What is the Return on Real Estate?
Commercial real estate is a solid investment that provides stability and appreciation over time. When you purchase commercial real estate, you are essentially buying property that will increase in value as the market grows. In addition, commercial real estate also provides a steady stream of income through periodic cash flows.
The return on real estate investment varies depending on several factors, such as the property’s location, condition, and current market conditions. However, over the long term, real estate tends to appreciate at a rate higher than most other investments, making it an excellent choice for those looking to build wealth.
What is the Internal Rate of Return (IRR)?
IRR is a profitability metric that measures an investment or project’s annualized rate of return. It’s the estimated compound annual rate of return earned on a project or investment. IRR evaluates an investment’s potential profitability.
Such external variables as the risk-free rate, inflation, cost of capital, or financial risk are ignored in the IRR calculation. In other words, IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.
IRR is calculated by taking the present value of all cash inflows from the investment or project and subtracting the present value of all cash outflows. The result is then divided by the total invested capital.
What is XIRR?
Like the IRR, XIRR is short for an Extended Internal Rate of Return. The commercial real estate definition of XIRR definition is that XIRR is a metric used to evaluate the performance of an investment over time. It considers the initial investment and subsequent cash flows, such as rental income or capital gains.
XIRR is calculated by taking the present value of all cash flows and dividing it by the initial investment.
When evaluating commercial real estate investments, it’s important to remember that the XIRR is simply one key performance metric to gauge your return. There are several factors to consider before investing, and the essential distinction will differ from person to person.
How do You Calculate XIRR?
To use the XIRR function, you need three pieces of information:
- The original investment amount;
- The current value of the investment;
- The date of each cash flow.
The XIRR function in Excel calculates the internal rate of return for a series of cash flows that may not occur at regular intervals. The internal rate of return is the rate of return that would make the present value of the cash flows equal to the invested amount. You can calculate XIRR after you’ve gathered all of this information.
XIRR Calculation Example
For example, if you’re thinking about investing $100,000 in a project that will result in $25,000 per year in cash flows for ten years, you may use the XIRR function to figure out how much interest would be required to make the present value of those future cash flows equal to $100,000.
To calculate XIRR in Excel, you’ll need to enter your invested amount, the date of each cash flow, and the corresponding amount. You can then use the XIRR function to calculate the internal rate of return.
For example, if you invest $100,000 on January 1st and receive cash flows of $25,000 on December 31st of each year for ten years, your XIRR would be 10%.
In this example, the original investment amount is the amount you originally invested in the property. The investment’s current value is the property’s current market value. The date of each cash flow was the date when each rent payment was received.
To calculate XIRR, enter these three pieces of information into the function. The XIRR function will then calculate the internal rate of return for your real estate investment.
XIRR vs IRR
XIRR considers the timing of cash flows when measuring the performance of an investment. This means that it is more accurate than the internal rate of return when comparing investments with different holding periods.
The IRR, on the other hand, is a simpler measure that only looks at the overall cash flow from an investment. This measure doesn’t consider the timing of cash flows. As a result, comparing different investments may not be as accurate.
Which Measure – XIRR or IRR – Should You Use?
If you’re looking for a simple way to compare investments, an internal rate of return is a good option. However, if you want a more accurate measure that considers the timing of cash flows, then the Extended Internal Rate of Return is a better choice.
IRR vs XIRR in Commercial Real Estate
The IRR is an excellent method for calculating real gains obtained from current assets. This is because, in most circumstances, estimating the financial success of a real estate project would require much guesswork. Still, it’s especially useful to real estate investors who wish to project future returns on potential purchases.
In commercial real estate investment, IRR is used in two distinct situations:
- When you are contemplating investing in a property or
- When you already have a property investment and want to know what to do with it.
The advantage of XIRR is that it provides a more accurate picture of the return on investment.
What is a Good XIRR?
If your investment is expected to generate a return of 10% per year for ten years, the XIRR would be 10%. However, if the cash flows are spread out over a longer period, the XIRR will be lower.
Businesses use the XIRR to compare investment opportunities and decide where to allocate their resources. When evaluating real estate investments, looking at the XIRR and other factors such as location, demographics, and economic conditions is important.
For real estate, a 12-15% XIRR is achievable, particularly if the property is long-term. If you want to achieve a high XIRR percentage, investing in quality real estate and having a solid exit strategy is important. With a little planning and smart investment, reaching or exceeding your goals is possible.
Advantages of XIRR
The XIRR method compares apples to apples. Comparing apples to apples isn’t easy since so many variables are involved. But with XIRR, you can plug in all the relevant data – purchase price, rental income that corresponds to the date in which you received, expenses, etc. – and get a clear picture of which investment is performing better.
- This is especially helpful when considering properties in different markets or with different types of tenants. Using XIRR, you ensure you get the most bang for your buck – no matter where you’re investing.
- Another advantage of using XIRR for real estate investments is that it accounts for the timing of cash flows. For example, if a property is purchased at the beginning of the year and sold at the end, all associated cash flows will be considered when calculating the return. Other techniques (such as annualized returns) would look at the purchase and sale prices, which wouldn’t accurately assess the investment’s performance.
- Lastly, XIRR can compare investment opportunities with different timelines. For example, if two properties are being considered for purchase, but one will take longer to sell, XIRR can be used to see which one provides the better return. This flexibility makes XIRR an invaluable tool for real estate investors.
Disadvantages of XIRR
XIRR has a few disadvantages that real estate investors should be aware of.
- If you evaluate an investment in real estate, the order in which you input the cash flows significantly impacts the XIRR calculation.
- In addition, the XIRR function assumes that all cash flows occur at the end of the period, which may not be accurate for some investments.
As a result, it is important to use caution when using the XIRR function and to consider all assumptions before concluding the results carefully.
XIRR vs. CAGR
Regarding real estate investing, there are two main ways to measure return: the internal rate of return (XIRR) and the compound annual growth rate (CAGR). Both methods have pros and cons, so it’s important to understand their differences.
XIRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. It doesn’t account for the time value of money, which can lead to incorrect conclusions.
CAGR, on the other hand, is much simpler to calculate, and it provides a good way to compare different investments.
Ultimately, which metric you use is up to you. If you’re looking for a more accurate picture of an investment’s return, XIRR is the way to go. But CAGR is another key performance metric if you’re looking for a simpler metric that’s easy to compare across different investments.
XIRR vs. ROI
Both ROI and XIRR are important metrics to keep track of when assessing your real estate investments. Both measure how much money you make on an investment, but they differ in how they consider the timing of cash flows.
ROI is a pretty straightforward metric. It simply measures the percentage return on your investment for that period only. For example, if you invested $100,000 in a property and it increased in value by $10,000 over a year, your ROI would be 10%.
XIRR is a little more difficult to calculate. When evaluating returns, it considers the timeliness of cash flows. As a result, if you bought an investment property that didn’t sell as quickly as expected, your XIRR would be adversely affected.
Conversely, if you could quickly refinance the property and pull out some equity, that would boost your XIRR. Because of this, XIRR is a more accurate measure of true profitability.
ROI and XIRR have their uses, so it’s important to consider both when evaluating real estate investments.
XIRR is a helpful tool for real estate investors, but it’s important to understand the pros and cons before using it. As with any tool, caution is important, and consider all assumptions before concluding results.
About The Author
Please note that Point Acquisitions is not a tax expert or tax advisor. The information on our blogs and pages is for general informational purposes only and should not be relied upon as legal, tax, or accounting advice. Any information provided does not constitute professional advice or create an attorney-client or any other professional relationship. We recommend that you consult with your tax advisor or seek professional advice before making any decisions based on the information provided on our blogs and pages. Point Acquisitions is not responsible for any actions taken based on the information provided on our blogs and pages.
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