Simply put, the Internal Rate of Return (IRR) will determine the average yield of an investment over a period of time. It is, technically, a discount rate which, when applied to both inflows and outflows of cash over the economic life of the investment, will provide a net present value equal to zero.
For a property that is revenue generating, the IRR calculation makes use of the original amount invested, the projected after-tax cash flows, and the projected sales proceeds amount, after tax, for any given year. Basically,, the IRR gives an investor an indication how hard an investment amount is working over the term of the investment, irrespective of the income distribution pattern. This is important, because the IRR is considered by accountants and investors alike as the truest way to compare two unlike investments.
It’s also important to note two important considerations: 1) that if cash flows swing back and forth between positive and negative, it may result in more than one IRR and 2) the IRR assumes that reinvestment rates will be identical to the original rate of investment.
Some investors prefer to use the Modified Internal Rate of Return, which modifies cash flows for realistic assumptions as regards reinvestment and borrowing rates, establishment of sinking funds, etc.
IRR calculators and software are available online, both free and fee-based.