What is IRR?
Internal rate of return (IRR) is a measure of an investment's profitability. It is the annualized rate of return that is earned on an investment over time, taking into account the time value of money.
To calculate IRR, an investor will typically compare the present value of an investment's expected cash flows to the initial investment amount. The IRR is the discount rate at which the present value of the expected cash flows is equal to the initial investment amount.
For example, if an investor expects to receive $1,000 in one year, $1,500 in two years, and $2,000 in three years from an investment, and the initial investment amount was $3,000, the IRR would be the discount rate at which the present value of those expected cash flows is equal to $3,000.
IRR is often used to compare the profitability of different investment opportunities, as it allows investors to compare the returns from investments with different cash flow streams and holding periods. However, it's important to note that IRR is just one measure of an investment's profitability, and it's important to consider other factors as well when evaluating investment opportunities.
What is ARR?
Annualized rate of return (ARR) is a measure of an investment's profitability that is expressed as a percentage. It represents the average annual return that an investor can expect to earn on an investment over a given period of time.
To calculate ARR, an investor will typically divide the total return on an investment by the number of years the investment was held, and then express the result as a percentage. For example, if an investor invested $10,000 in a stock and sold it for $15,000 after three years, the total return on the investment would be $5,000 ($15,000 - $10,000). The ARR for this investment would be calculated as follows:
ARR = ($5,000 / $10,000) / 3 years = 0.5 / 3 years = 16.67%
ARR is often used to compare the profitability of different investment opportunities, as it allows investors to compare the returns from investments with different holding periods on a comparable basis. However, it's important to note that ARR is just one measure of an investment's profitability, and it's important to consider other factors as well when evaluating investment opportunities.
In multifamily investing is ARR or IRR a better way to measure your return on investment?
Both the internal rate of return (IRR) and the annualized return on investment (ARR) are commonly used metrics to evaluate the performance of a real estate investment. However, each metric has its own advantages and disadvantages, and which one is the "better" measure can depend on your specific investment goals and circumstances.
IRR is a measure of the rate of return on an investment, taking into account the timing and size of cash flows. It is typically expressed as a percentage, and it represents the discount rate at which the present value of the investment's future cash flows equals the initial investment amount. IRR is a useful measure for comparing investments with different cash flow patterns and for ranking projects based on their expected return. However, IRR can be sensitive to the assumptions made about future cash flows and the discount rate, and it can be affected by the length of the investment period.
ARR is a measure of the average annual return on an investment over a specific period of time. It is expressed as a percentage and is calculated by dividing the total return on the investment by the initial investment amount, and then multiplying by the number of years in the investment period. ARR is a simple and straightforward measure that is easy to understand and compare across investments. However, it does not take into account the timing or size of cash flows, and it can be affected by changes in the value of the investment over time.
Ultimately, the choice between IRR and ARR depends on your investment goals and the information you have available. If you are primarily concerned with the timing and size of cash flows, IRR may be a better measure. If you are more interested in the overall return on your investment over a specific period of time, ARR may be a more appropriate metric. It is also worth considering using both IRR and ARR to get a more complete picture of the performance of your investment.
