There are a lot of different ways to measure investment performance but two of the most common and most popular metrics for evaluating the potential profitability of a real estate investment are return on investment (ROI), which is a fairly simple concept, and internal rate of return (IRR), which is more complicated. While they serve a similar function and are sometimes used interchangeably, there are critical differences between the two metrics.
Similarities between IRR and ROI
Both IRR and ROI can serve to represent the average annual return of an investment and can be used either as a forward-looking estimate of performance or a backward-looking evaluation of a completed investment. As always, it’s important to consider the assumptions that go into the calculations when using them as predictive tools about future earnings.
In the case of IRR vs. ROI, all of the associated details and assumptions for an investment are boiled down into a single percentage allowing for quick evaluation and comparison of multiple investments.
Differences between IRR and ROI
While most people will say that IRR is more complex and harder to calculate than ROI, the primary difference really has to do with the fact that IRR takes into account the time value of money (TVM) while ROI does not.
IRR formula:
The formula may look intimidating, but it breaks down into fairly straightforward components
NPV: NPV (Net Present Value) is the sum of the present values of incoming and outgoing cash flows over a period of time.
N: The total number of periods in the span of time being evaluated. This often represents the total number of years.
Cn: Cash flow in the current period at that step in the formula.
r: Represents IRR. This is the value you’re solving for.
n: The current period at that step in the formula.
ROI formula:
ROI = (Gain from Investment - Cost of Investment) / Cost of Investment
In the above formula, "Gain from Investment” refers to the proceeds obtained from the sale of the investment of interest. Because ROI is measured as a percentage, it can be easily compared with returns from other investments, allowing one to measure a variety of types of investments against one another. Although seemingly simpler, just think about how much goes into predicting the “Gain from Investment” and all the unplanned circumstances that may arise during an investment that could affect it.
To understand the fundamental difference between the two metrics, think about the following example. Imagine a project with a total ROI of 15%. This could be great if the investment was only for one year but how great is it if the investment is over a 30 year period? Simply relying on ROI as a single metric would not take into account the length of time of the investment. Conversely, IRR does take into consideration both the amount and the timing of the return, which allows for a more precise evaluation of the potential performance of a given investment.
Using IRR and ROI together
As discussed above, both IRR and ROI have strengths and weaknesses. ROI can be simpler to understand conceptually, but doesn’t account for the time value of money. IRR incorporates the timing of the return, but may require more work to accurately calculate. When used together both metrics can provide valuable insight into an investment’s past or potential future performance.
While IRR is better suited for evaluating potential long term investments, ROI may provide a sufficient “back of the envelope” picture for shorter term investments. As always, the key is to fully evaluate a potential investment and remember that the more assumptions that go into your evaluations, the greater the chance that things won’t go exactly as planned.