Internal Rate of Return (IRR)

When you have an investment that creates differing amounts of annual cash flow, you need to determine your rate of return using the Internal Rate of Return (IRR).   The formula for computing the IRR is very complicated but essentially an IRR is the rate needed to convert (or discount) the future uneven cash flow to your initial investment or down payment.

A very simple example is say that you will have a cash flow of $10 in year 2.  Assume that in order to generate that cash flow, you had to invest $50.  Thus you have an out flow of $50 the first year, and an inflow of $60 in year two ($10 earnings plus the $50 return of your initial investment).  In order to convert or discount the $60 back to today's dollars to equal $50, you must use a discount rate of 20%.  Thus, your IRR is 20%.

Another way to look at it is the internal rate of return (IRR) is the discount rate at which the "net" present value of future cash flows is zero (discounted future cash flows = starting investment amount).  The "net" meaning you subtract your initial investment.

Leveraged vs. Unleveraged IRR

When you use debt to purchase a property, then you are using leverage.  The program computes your IRR based on how debt impacts your cash flow.  The program automatically backs out interest and debt payments and calculates an Unleveraged IRR assuming 100% down payment. 

You can compare the leveraged and unleveraged IRR's to determine how debt is helping or hurting your investment results.