AAR vs IRR in real estate

AAR vs IRR: Which Metric Should You Use?

Average Annual Return (AAR) in real estate is a simple calculation showing the annual return over a set period, not accounting for the time value of money. Internal Rate of Return (IRR) is a more complex metric that considers the time value of money, calculating the annual growth rate by discounting future cash flows to present value. While AAR provides a basic overview of investment performance, IRR offers a detailed and time-sensitive analysis, making it more suitable for comparing profitability in real estate investments with varying cash flow patterns.

Average Annual Return (AAR)

  • AAR is a simpler calculation that represents the average yearly return of an investment over a specified period.
  • It is calculated by dividing the total return of the investment by the number of years in the investment period.
  • AAR does not take into account the time value of money. It treats all returns equally, regardless of when they are received during the investment period.
  • In real estate, AAR can be useful for getting a quick, straightforward sense of an investment's performance over time.

Internal Rate of Return (IRR)

  • IRR is a more complex and sophisticated metric used in real estate to evaluate the profitability of potential investments.
  • It is the annual rate of growth an investment is expected to generate, calculated by equating the net present value (NPV) of all cash flows (both in and out) from the investment to zero.
  • IRR accounts for the time value of money, which means it considers when each return is received and discounts future cash flows to present value.
  • In real estate, IRR helps compare the profitability of different investments, especially those with varying cash flow patterns.

AAR offers a basic, time-agnostic view of investment returns, while IRR provides a more detailed, time-sensitive analysis. IRR is generally preferred in real estate investment analysis because it provides a more accurate picture of the investment’s potential performance, especially for projects with uneven cash flows or different investment periods.

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