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Key Takeaways
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ARR is formula that calculates the annual percentage rate of return expected from an investment, compared to its initial cost.
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ARR is a simple calculation that can be done on the back of a napkin.
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IRR is a more complex equation that is best calculated with a spreadsheet or calculator.
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IRR stands for Internal Rate of Return. It lets you estimate the future profitability of potential investments.
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IRR lets you factor in the time value of money, which ARR does not.
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IRR is preferable if you won’t earn cash flow from an investment evenly over time.
IRR vs. ARR: What’s the Difference?
As a real estate investor, your goal should be to grow your wealth year over year. Given this, how can you compare different investments in order to decide whether or not to jump in?
You will need a simple way to gauge the profitability of each investment before you invest.
The answer to this lies in two accounting metrics known as the ARR and IRR. Don’t worry if you’re unsure what these are or how to choose because you’re in the right place. Keep reading to learn everything you need to know, including how to choose between IRR vs. ARR.
What Is ARR?
Before we compare ARR vs. IRR, let’s ensure we’re on the same page with a few investing terms. First, ARR is the acronym for Accounting Rate of Return. This term is also called Annual Recurring Revenue by many.
This term refers to a quick measurement that can help investors determine the profitability of their investments.
Specifically, ARR is a mathematical formula that calculates the annual percentage rate of return expected from an investment, compared to its initial cost.
To calculate the ARR, you simply divide the annual predicted net profit by your initial investment, as shown below.
Annual Predicted Net Profit / Initial Investment = ARR
For example, if you think you will make $15K in profit annually over the lifespan of a $100K investment, then your ARR would be 15%.
This is because: $15K / $100K = 0.15 = 15% ARR.
Alternatively, you can you take your projected total net profit, divide that by the number of years the money will be invested and then divide that by your initial investment.
Total Net Profit / # of Years Money Is Invested / Initial Investment = ARR
For example, if you plan to make $75K in profit over the course of 5 year investment in which you invest in $100K in capital, then your ARR would again be 15%.
This is because: $75K in Profit / 5 Yrs / $100K = 0.1 = 15% ARR.
Using ARR to Assess a Real Estate Investment
One the most common places you will see an Accounting Rate of Return (ARR) used is with real estate investments. It is also frequently used to assess businesses that are listed for sale.
For example, you might be offered the opportunity to invest in a real estate syndication, but you want to assess if it is a good deal. In researching this new opportunity, you find that you can become one of their investors for $100,000.
The sponsor shows you the property and a predicted profit of $500,000 over the next five years that will be shared between 10 different investors. This means that each investor would get 1/10th of the total expected profit. Meaning, each investor is projected to get $50,000 over the lifespan of the investment.
To find your ARR, you first break down the profit per year for each investor, giving you an annual estimated return of $10,000 per year.
You divide that by your $100,000 initial investment ($10,000 / $100,000 = 0.1 = 10%), giving you a 10% ARR.
Drawbacks of Using ARR
Unfortunately, using ARR in this situation will probably be misleading, because your investment is unlikely to pay out exactly the same amount of money ($10,000) each year that you own it. More likely, you’ll earn less from your investment in its early years and more from it in its later years.
In the real estate industry, this is common because you can raise rents over time while simultaneously paying down your debt (mortgage). The result of this is that your investment will tend to become more profitable year-over-year.
Also, real estate tends to involve one or more large “exits”, which we in the field like to call “capital events” because there is money involved.
These can be in the form of a cash-out refinance or from the sale of an asset. Thus, the money you earn from a real estate investment is usually not paid out evenly over time. More likely, you will receive smaller increments of money early in the lifespan of the investment, followed by a lump sum payout when the asset is sold.
For example, a real estate investment might pay you the following:
$100,000 initial investment
Year 1 – $2,000 in profit
Year 2 – $3,000 in profit
Year 3 – $4,000 in profit
Year 4 – $5,000 in profit
Year 5 – $36,000 in profit plus $100K return of capital (when the asset is sold)
In the example above, the total profit received over five-years is again $50,000. It should go without saying that this profit is based on each investor receiving their initial investment back.
For this example, the ARR is 10% per year, because you are earning $50,000 over a five-year period on a $100,000 investment.
But, it is very important to note that the profits from this investment are not projected to be paid out evenly over time.
Given that money has a distinct time value to it, this is why the IRR can give you a better idea of your predicted profit over a given span of time.
In the example above where you won’t collect the majority of your profits until year 5, so you will have to wait quite a while to be able to reinvest your funds.
For this reason, I strongly prefer using IRR over ARR to assess real estate investments and believe that IRR should be used anytime that cash flow won’t be paid out evenly over time.
What Is IRR?
When it comes to evaluating business opportunities or investments, IRR is usually a more desirable metric to use than ARR. IRR is the acronym for Internal Rate of Return and it refers to how analysts measure and estimate the future profitability of potential investments.
Your goal in determining the IRR is to calculate the growth rate your potential investment will provide to you each year on an annualized basis.
Choosing the best cash flow investments can mean the difference between continuing to grow your business or going out of business.
While IRR is a bit more tricky to determine than the ARR, you can calculate it quickly by using a program such as Excel or Google Sheets. You also do quick IRR calculations using an online IRR calculator, like this one that I love.
IRR Example
To show you why IRR is usually the preferable metric to use, let’s go back to our previous example, where cash flow from your investment is projected to look like this:
$100,000 initial investment
Year 1 – $2,000 in profit
Year 2 – $3,000 in profit
Year 3 – $4,000 in profit
Year 4 – $5,000 in profit
Year 5 – $36,000 in profit plus $100K return of capital (when the asset is sold)
As before, the total profit received over five-years is $50,000 and we are assuming that each investor receives their initial $100,000 investment back.
Based on these numbers, your IRR is not 10%. It will actually be substantially lower, coming in at only 8.858%.
You can see these calculations in the screenshot below, where I used a simple IRR calculator.
To produce an IRR of 10%, you must be paid your profit distributions evenly over time. Meaning, your investment earning $50,000 over 5 years would have to look like this:
$100,000 initial investment
Year 1 – $10,000 in cash flow
Year 2 – $10,000 in cash flow
Year 3 – $10,000 in cash flow
Year 4 – $10,000in cash flow
Year 5 – $110,000 in cash flow (when the asset is sold)
As you can see from those two IRR calculations above, when you collect your cash flow and profits from your investment dramatically impacts your total IRR.
For this reason, if someone is presenting a real estate syndication to you in the form of an ARR—or any investment opportunity for that matter— I would recommend that you also ask to see the projected IRR.
More often than not, an investment’s IRR will be lower than its ARR.
IRR Accounts for The Time Value of Money
Investing can be tricky, but when it comes to the Internal Rate of Return versus Annual Rate of Return, both can give you a quick metric by which you can compare investment options.
As mentioned, if you find yourself in a position where you need to choose between investment opportunities, metrics such as the ARR and IRR can help you identify the best option for your portfolio.
Generally speaking, IRR is a more complete metric, because it will allow you to account for factors like depreciation and the time value of money.
By the time value of money I simply mean two things:
- Your money will become worth less over time because of inflation, which averages about 3.22% per year. Thus, it’s better to have $100 today than to have $100 in five years.
- It’s preferable to be able to re-invest your money sooner than later into a new investment, because this will allow you to multiply it more rapidly.
In contrast, if you want a quick, easy-to-use metric that can be used to facilitate faster decision-making, then the ARR might be the best choice for you. The simple reason for this is that ARR is easier to calculate.
The Key Differences Between IRR and ARR
When assessing a real estate investment or business opportunity, you’ll need to make accurate and smart decisions quickly. Metrics such as the IRR and ARR can help you make sound choices.
Regardless of which metric you choose when deciding between IRR vs. ARR, the key is to remember that IRR takes the value of time into account while ARR does not.
Put simply, ARR is a simple mathematical equation that anyone can do on the back of a napkin. The benefit of this is that you can make really fast decisions. It can also help you compare several different investments quickly, in order to narrow down which ones deserve a deeper look.
But, if you want to make accurate financial decisions based on when in time you will receive your expected profit distributions, then you should really use IRR. While IRR requires a more sophisticated calculation, today’s IRR calculators will easily let you crunch your expected annual returns.