For a conventional investment with an initial outflow and subsequent benefits, what defines an internal rate of return?
Correct Answer
C) The discount rate at which the present value of all cash flows nets to zero.
IRR solves the discounted cash-flow equation with net present value equal to zero. It can describe a property or equity stream depending on the cash flows modeled. It is not inherently only an equity rate; unusual sign-changing cash flows may have multiple or no meaningful IRRs.
Why This Is the Correct Answer
Option C is correct because the IRR is the yield or discount rate at which the present value of expected cash inflows equals the present value of cash outflows, so the present value of all cash flows nets to zero. For a conventional investment, this is the rate that makes NPV equal zero.
Why the Other Options Are Wrong
Option A: A rate that makes the reversion equal the initial purchase price.
Option A defines the IRR as a rate making the reversion equal the purchase price. The IRR considers all cash flows, including periodic income, not just a comparison of resale to price.
Option B: A rate that makes the annual NOI exactly equal the annual debt service.
Option B links the IRR to making annual NOI equal annual debt service. That describes a break-even financing relationship, not a discount rate that sets the present value of all cash flows to zero.
Option D: A rate determined by the property’s operating expense ratio.
Option D says the IRR is determined by the operating expense ratio. The expense ratio is an operating measure; the IRR is solved from the amounts and timing of all cash flows.
IRR makes NPV zero
The internal rate of return is the one discount rate that makes net present value equal zero.
How to use: Use this phrase to recognize the correct IRR definition among answer choices.
Exam Tip
Look for a definition that involves discounting all cash flows; choices built on a single ratio or a single year are describing something else.
Common Mistakes to Avoid
- -Confusing IRR with an overall capitalization rate
- -Thinking IRR considers only the reversion
- -Assuming IRR always refers only to equity
Concept Deep Dive
Analysis
This question tests the definition of the internal rate of return. The IRR is the discount rate that equates the present value of expected inflows with the present value of outflows, which means net present value equals zero.
Background Knowledge
The IRR is a yield measure that accounts for the amount and timing of all cash flows over the holding period. It can be measured for the whole property or for the equity position depending on which cash flows are modeled, and unusual cash flows with multiple sign changes can produce more than one IRR or none.
Real-World Application
An investor's analyst projects a property's purchase price, annual cash flows and resale. The appraiser checks the analysis by solving for the discount rate that makes the present value of those flows net to zero, which is the projected IRR.
More Income Approach Questions
Which model describes yield capitalization of property benefits?
An appraiser is valuing a duplex. A market survey of recent duplex sales reports prices at 10.8 times potential gross income, with stabilized vacancy and credit loss of 10% of PGI and no other income. The subject's rent schedule is unavailable, but the property manager's records show collected income of $54,000 a year, in line with market rent and the 10% market loss. What value is indicated?
The subject property is a fourplex with annual EGI of $72,000 and operating expenses of $28,800. Of those expenses, $18,000 is fixed and $10,800 varies in direct proportion to EGI. The owner's annual mortgage payments are $21,000. An appraiser projects that EGI will fall 10% because of higher vacancy. What is the projected NOI?
Annual NOI available for debt service is $168,000 and total annual mortgage principal and interest debt service is $120,000. What is NOI ÷ debt service?
Annual PGI is $250,000 and combined vacancy and collection loss is explicitly 12% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $360,000 and combined vacancy and collection loss is explicitly 8% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $640,000. Combined vacancy and collection loss is 6.25% of PGI. There is no other income. What EGI remains?
An appraiser is updating a prior appraisal of a triplex with potential gross income of $60,000 and no other income. The prior appraisal used vacancy and credit loss of 5% of PGI, and a new survey of competing rentals indicates 8%. The operating expenses of $24,000 are property taxes, insurance and contract services that do not vary with occupancy, and the market overall rate remains 7.5%. By what percentages do effective gross income and indicated value decrease?
Annual potential rental income is $600,000 and vacancy loss alone is $36,000. What percentage of potential rent does that loss represent?
In the subject's market, lenders on fourplexes have lowered their typical loan-to-value ratio from 70% to 60%. The annual mortgage constant remains 5% and the equity dividend rate remains 10%. The subject's NOI has not changed. How does this affect the overall rate indicated by the band of investment and the indicated value?
People Also Study
Real Estate Market
13.6% of exam
Property Description
11.8% of exam
Land or Site Valuation
4.5% of exam
Sales Comparison Approach
16.4% of exam
Cost Approach
13.6% of exam
Previous Question
An appraiser is analyzing four sales of rental houses with monthly gross rent multipliers of 147, 190, 195 and 200. Verification reveals the 147 sale was a discounted transfer between family members; the others were open-market sales of similar houses. The subject’s market rent is $2,600 per month, and the appraiser concludes to the average of the sales that reflect market value. What is the indicated value?
Next Question
The subject property has annual NOI of $198,000. Debt funds 70% of value at an annual mortgage constant of 9%, and the remaining equity requires an annual equity dividend rate of 12%. What value is indicated using an overall rate from the band of investment, rounded to the nearest dollar?