![]() Tax payment = ( NOI – Depreciation- Interest Payment) * Tax Rateĭebt Service = Mortgage Constant * Loan Amount ![]() We have discussed so far how Gross Effective Income, NOI, Tax Payment and Debt Service, are calculated but here are again the formulas for the last two: This means that all revenues and costs that enter the IRR analysis need to be projected to the future.Īs indicated earlier the estimation of an internal rate of return (IRR) involves typically the calculation of the after-tax cash flows of each period as follows. ![]() The analyst though still needs to accurately calculate the final cash flow for each period of analysis that is being used by the program in order to calculate the IRR.Īt this point, we have to emphasize the fact that the cash flows used to calculate the IRR of a real estate investment by definition refer to the future. For this reason, commonly used spreadsheet programs like Microsoft Excel have automated the calculation of an IRR over several periods. IRR = 0.28 or 28% Multiple-Period Internal Rate of ReturnĪs indicated earlier, solving for the internal rate of return (IRR) for multiple periods is not that simple and the mathematics become more complex the greater the number of periods over which the investment analysis is performed. By substituting these values in (22) we have: Let’s summarize the figures below:īased on the numbers below we can calculate, CF 1, the cash flow at the end of the first year when the property is sold:ĬF 1 = $12,000 – $4,000 + $120,000 = $128,000 Consider also that during the year the owner receives a rental income of $12,000 and has operating expenses of $4,000. The property is sold exactly after one year netting to the investor $120,000. To demonstrate with numbers how the one period IRR can be calculated let’s consider a rental property that is bought for $100,000, including all acquisition and pre-acquisition costs. Notice that in the formulas above -CF 0 represents a positive number sinse CF 0 represents acquisition/investment cost and is a negative cash flow to begin with. In this case, we have only two cash flows and so Equation (1) can be written as follows:īy transforming this equation we can solve for the one-period IRR, as follows: Solving the internal rate of return equation is easy for just one period, which usually in real estate analysis represents. ![]() We will examine in more detail in a following section how this resale price is calculated. This resale price is typically calculated using an exit capitalization rate, which is applied to the property’s Net Operating Income (NOI) at the time of anticipated resale. This cash flow may include not only the property purchase price, but also other acquisition costs, such as notary fees, other government fees associated with transfer of ownership, potential agency fees, legal fees, etc., and pre-acquisition costs associated with necessary due diligence work, such as engineering studies, market studies, feasibility studies, environmental studies, legal due diligence, etc.Īlso notice that the last cash flow CF n takes into account, and the property’s anticipated Resale Price, RP n in addition to any other income received from the property during that period. The first cash flow in the NPV formula, which is considered to take place in time 0, CF 0, represents the investor’s original investment cost for acquiring ownership of the property. In analyzing any real estate investment, the analyst can calculate either an unleveraged internal rate of return (unleveraged IRR), which assumes that the property is acquired using only the investor’s money and a leveraged internal rate of return (leveraged IRR), which takes into account the effect of borrowing on cash flows. The IRR is typically calculated using the after-tax cash flow of each period, which takes into account all revenues and expenses associated with property ownership. For example, Microsoft Excel includes an internal rate of return (IRR) function, which can be used to calculate it, once the user supplies the property’s net cash-flow stream period-by-period. However, because the solution of this equation is complex, especially when more than two periods are involved, the internal rate of return calculation is carried out through computer programs. Solving the above formula with respect to the internal rate of return (IRR) will provide an estimate of this return measure.
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