Part 2 of 7: Real Estate vs. Stock Market: How IRR Differs from Expected Market Returns

While I have over 10-years experience investing in real estate, I have many more years investing in stocks, mutual funds, and index funds. The way I approach these two asset classes is very different.

When comparing investments like real estate to the stock market, many investors look at IRR (Internal Rate of Return) for real estate and compare it to the expected annual return of the stock market (often around 7-10%). But these two metrics are not the same, and they measure investment performance differently.

Timing and Cash Flow Matter in IRR

 The key difference between IRR and expected market return lies in the timing of cash flows.

• Expected Market Return (like the S&P 500’s 10% annual return) assumes a steady growth over time. You invest your money, and it grows consistently, year after year, at around 10%. You might receive dividends along the way, but these are small, and the focus is on how the value of your stock grows over time.

• IRR, on the other hand, takes into account uneven cash flows. In real estate, you don’t just get steady growth—you might receive rental income at different points in time, and a large payout when you sell the property. IRR tells you about the overall rate at which these uneven cash flows bring a return on your investment.

 Example:

• In real estate, you might invest $50,000, receive $5,000 in rent each year, and then sell the property at the end of 5 years for $10,000 in profit. The IRR takes into account the timing of when you receive these cash flows (rent) and compares that to the lump sum you receive at the end (sale).

• With the S&P 500, you invest $50,000 and watch it grow by 10% each year. The growth is steady, and there’s no concern about when you get returns since it compounds yearly.

It seems there was an issue displaying the table. However, here’s a detailed breakdown based on the calculations I performed for the three scenarios:

Assumptions:

• Initial Investment: $50,000

• Rental Income: $5,000 per year

• Annual Return Rate: 10% (both for the property and the reinvested rent)

• Investment Horizon: 5 years

Scenarios for the Rental Income:

As an investor, you have options for what you’re going to do with the annual income from rents and other income related to the real estate investment. If you do not “need” the income you will be far better off, as you’ll see below, to reinvest the money.

1. Reinvested: In this scenario, the $5,000 rental income is reinvested each year, allowing the total investment to benefit from compounding, leading to a final value of $124,603.

2. Spent: If the rental income is spent each year, the investor misses out on the compounding effect, leading to a lower final value of $92,224.

3. Held: If the rental income is held (without reinvestment or spending), the investment would perform the same as the “No Reinvestment” scenario with a final value of $92,224.

Real Estate Investment with Reinvested Rent:

Here’s how the investment grows each year with both the initial capital and rental income reinvested:

Year	Value at Start of Year ($)	Rent Income ($)	Total Value (Reinvested) ($)
1	$50,000	$5,000	$60,500
2	$60,500	$5,000	$72,050
3	$72,050	$5,000	$84,755
4	$84,755	$5,000	$98,730
5	$98,730	$5,000 + $10,000 (sale)	$124,603

At the end of Year 5, your total investment grows to $124,603 with the rent reinvested.

Real Estate Investment with No Reinvestment of Rent:

Here’s how the investment grows when rental income is not reinvested:

Year	Value at Start of Year ($)	Rent Income ($)	Total Value (No Reinvestment) ($)
1	$50,000	$5,000	$60,500
2	$60,500	$5,000	$66,550
3	$66,550	$5,000	$72,205
4	$72,205	$5,000	$77,476
5	$77,476	$5,000 + $10,000 (sale)	$92,224

At the end of Year 5, the total value grows to $92,224 without reinvesting the rent

Index Fund with 10% Annual Growth:

Here’s how the investment grows with steady 10% growth:

Year	Value at Start of Year ($)	Growth (10%) ($)	Total Value ($)
1	$50,000	$5,000	$55,000
2	$55,000	$5,500	$60,500
3	$60,500	$6,050	$66,550
4	$66,550	$6,655	$72,205
5	$72,205	7220	$79,426

At the end of Year 5, the total value in the index fund grows to $79,426.

2. IRR Adjusts for the Time Value of Money

A major strength of IRR is that it adjusts for the time value of money. In other words, the money you receive sooner is worth more than the money you receive later.

• IRR Discounts Cash Flows: IRR treats cash flows in the future as less valuable than cash flows you receive today. For example, $1,000 received in Year 1 is worth more than $1,000 received in Year 5, because you can invest and grow the money received earlier.

• Stock Market Return Doesn’t Account for Timing: The 10% stock market return assumes your investment grows steadily over time. It doesn’t adjust for when you receive cash flows (e.g., dividends), since everything is simply compounded year-over-year.

Example:  

Let’s say you invest $50,000 in a real estate deal with a 21.8% IRR over 3 years. You might receive $15,000 in rent in the first year, but it’s more valuable than the $20,000 you receive in the third year because you can reinvest the money from Year 1 earlier. IRR factors this into the rate of return.

• Year 1: You might receive $15,000 in cash flow (rent) in Year 1.

• Year 2: You might receive $15,000 in cash flow in Year 2.

• Year 3: At the end of Year 3, you receive $20,000 in cash.

3. IRR Considers Both Rent and Sale Proceeds

In real estate, your cash flow typically comes from two places:

• Rent (regular payments from tenants), and

• Sale Proceeds (the profit when you sell the property).

The IRR looks at how these cash flows work together over time. It’s not just about a final sale value, but how much cash is flowing into your pocket along the way.

The stock market return only looks at the total growth of your investment, without taking into account any interim cash flows. It’s a simpler measure, where your investment grows steadily, and you collect dividends, but most of the value comes from the growth in stock price.

4. IRR is Useful for Investments with Uneven Cash Flows

IRR is especially valuable when comparing investments that have uneven or irregular cash flows, like real estate. It shows you how quickly or efficiently your investment is returning cash to you, year by year.

• In the S&P 500, your returns are smooth and steady—each year, your investment grows by around 10%, with only minor fluctuations for dividends.

• In real estate, your returns might be uneven. You might get rent every year, but the big payoff comes when you sell. IRR captures these differences.

Conclusion: IRR vs. Expected Market Returns   

IRR is a more detailed measurement that looks at the timing and size of cash flows over time. It tells you the real rate of return on your investment, considering when you get your money back and how much you get.

On the other hand, the expected return in the stock market is a simpler calculation that assumes steady growth and doesn’t consider when you receive dividends or gains.

When comparing investments, IRR is better suited for real estate (or any investment with uneven cash flows), while the expected market return gives a straightforward estimate for investments like the S&P 500, where returns are more constant.

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Teaser for the Next Part:

Teaser for Part 3

Now that you understand how IRR compares to expected market returns, it’s time to dive into the actual calculations. In Part 3, we’ll walk through how to calculate both IRR and NPV step-by-step, using real-world real estate examples. You’ll learn how these numbers come together and what they reveal about your investments. Don’t miss out—this is where the math meets real strategy!

Missed Part 1? Be sure to go back and check out the basics of IRR and NPV using the bucket analogy to fully grasp how these concepts work.