When purchasing commercial real estate, the internal rate of return (IRR) calculation is often used to determine investment suitability. This calculation, which gives you the yearly return on equity after adjusting for expenses, rents, loan payments, and tax opportunities, is different than the return on investment (ROI), which accounts for total growth from start to finish.
Since the IRR is one of the best profit indicators, we thought we would share how to calculate this metric to measure a property’s potential annualized return.
Estimate Your Investment Property’s IRR
For commercial real estate investments, the upfront IRR calculation is valuable when searching for a property or working your exit plan, as it identifies your potential annualized return based on educated estimations. A positive IRR indicates a return on your investment. A negative IRR suggests a potential loss.
Use these five steps to formulate your potential IRR:
- Calculate the Net Present Value (NPV).
- Identify the principal paydown.
- Factor in potential tax opportunities.
- Estimate the date you will sell.
- Approximate the future sale price.
1. For an Estimated IRR, Get Net Present Value (NPV) to Zero
IRR is closely tied to the net present value (NPV), which is the difference between a property investment’s market value and its total cost. It is an estimation of the amount of actual cash flows. Any investment with a positive NPV will make money, just as any investment with a negative NPV will lose money.
When looking at commercial real estate, most often, you will only see deals that project a positive NPV, as nobody will bring a property to market advertising a loss. Therefore, it is important that you understand how to estimate the NPV and IRR.
To calculate NPV, use the proper discount rate, or interest rate, that sets the property’s cash flow to zero. The discount rate is the same for both cash inflows and outflows, which affects lending or borrowing. Usually, the weighted average cost of capital or the return rate on unconventional investments is used.
If the NPV is lower, the discount rate would be higher. Investments with higher risk have a higher discount rate than lower-risk investments.
NPV Single Investment Formula: Net Present Value = Present Value – Investment
Now that you have a better understanding of NPV, we can better examine how IRR is calculated.
2. Identify Principal Paydown
If you are obtaining a mortgage on your CRE investment, do you plan to pay more toward principal than required to pay the loan off faster? If so, when you sell, you may realize a higher ROI, but the extra payments may detract from your annual IRR. This needs to be factored into your equation.
3. Look at Tax Opportunities
Depending on the type of commercial real estate you purchase, a few tax opportunities can preserve capital, build wealth, and increase the annual IRR including:
- If you purchase property in one of the nine states with no state income or capital gains tax.
- Cost segregation depreciation(CSD), which will drastically accelerate depreciation of certain building expenses over five, seven, or 15 years, versus 27.5 or 39 years. This achieves significant tax savings on new and existing buildings and frees up capital for immediate cash flow.
- Some triple-net properties have the added benefit of accelerated depreciation. Many gas stations, oil change stations, and more have 15-year depreciation schedules.
4. & 5. Estimate the Sell Date & Sell Price
When you buy commercial real estate, it is important to have an exit plan from the start. This exit plan should have an estimated date of sale and the projected resale value. If you plan to own the property for 10, 15, or 20 years, this will affect your principal paydown, what you owe when you sell, and the tax basis.
The IRR reflects the timing of your investment’s future cash flows and weights them accordingly.
Figuring the IRR for NNNs vs. Gross Lease Properties
You will find the IRR calculation less straightforward for gross lease and modified gross lease commercial real estate than with other investments. Figuring the IRR is most complicated with gross lease properties, as these high-maintenance, higher-risk properties are very unpredictable. These properties tend to have less favorable financing, wildly fluctuating costs, tenant vacancies, and shifting resale value.
Triple-net (NNN) lease property investments, by contrast, have long-term, corporate-guaranteed leases with built-in rent escalations, high-credit tenants, and typically, a predictable resale value. They are stable with less risk, which means they usually garner better interest rates and financing terms. For the last decade, even in tough economic climates, NNN investments have been in high demand with very few changes to cap rates.
The expense-free nature of NNNs and the ability to write off depreciation and interest, combined with other financial benefits, including the power of possible positive leverage, can turn a 5.00–6.50% capitalization rate (cap rate) into a 7–10% IRR. This creates wealth without the uncertainty that’s inherent in other CRE, and stocks and bonds.
If you perform due diligence before purchasing a NNN investment using informed estimations of NPV and IRR, the annual IRR should be close to or better than your predictions, leaving you with a healthy annual income and a return on investment should you decide to sell.
Absolute NNN investments may surprise you with healthy, uncomplicated, adjusted returns of up to 10%. They preserve cash flow, yield a reliable, passive monthly income, and a predictable IRR with little, if any, risk of loss. – Jason Simons, VP, Westwood Net Lease Advisors
To Wrap it Up – Calculate IRR Before Your Purchase Commercial Real Estate
When considering a commercial real estate investment, it is good practice to understand how to calculate the IRR before you purchase, and why an accurate estimation of this measurement is important. Luckily, estimating the IRR can be relatively simple with an IRR calculator, and even simpler if you engage a Westwood Net Lease Advisor who will do it for you.
Our team has decades of experience in helping new and veteran investors alike with the commercial real estate buying process. We specialize in NNN lease investments and 1031 exchanges, and guide our buyers through the process with ease, starting with education and advocacy, all the way through closing, at no cost. Our no-obligation conversations are free, so reach out today. We look forward to meeting you! 314-997-5227