In a previous article, I discussed the shortcomings associated with using either internal rate of return (IRR) or net present value (NPV) as a return measure for income-generating real estate investments.
In this article I have also indicated that there are several other return measures that I prefer and which will be the subject of discussion here. Please note that these metrics are not perfect, but in my experience they are stronger and more reliable indicators than IRR or NPV.
As described in my previous article, the main flaw of the IRR is that it assumes that all positive outflows will be reinvested at the same rate as the IRR. Because this is rarely the case, IRR numbers are often biased, sometimes significantly.
The Modified Internal Rate of Return (MIRR) mitigates this problem by assuming that the present values of cash outflows are calculated using the financing rate, while the future values of cash inflows are calculated using the actual reinvestment rate.
Without getting too technical, the formula used to calculate MIRR can be described as “the nth root of the future value of positive cash flows divided by the present value of negative cash flows minus 1.0, where “n” is the number of periods .
Calculations like the above can be bypassed by simply using the MIRR formula in Excel. For a case where the cash flows are listed in cells A2 through A8 using a reinvestment rate of 7.0% and a financing rate of 5.0%, the formula would be: =MIRR (A2:A8, 0, 05, 0.07)
However, for this formula to work, there must be at least one negative cash outflow. For cases with no negative cash flows, the “long hand” formula above must be used.
Essentially, the MIRR formula is simply a geometric mean, identical to the formula used to calculate the cumulative average growth rate for numbers that increase exponentially, such as B. Compound Interest Income.
Because many real estate investments (hopefully) do not experience periods of negative cash outflows, the above calculation can be cumbersome, especially in situations involving an investment horizon that spans many periods. Regardless, since the final calculation will likely be more accurate than a similar IRR number, it’s worth the extra time to generate it.
There are two other investment moves that I rely on, perhaps more than any other. These include the net return on equity and the old pillar, the capitalization rate. If you’re reading this article, you’re probably familiar with both metrics, but in case you’re not, the formula used to calculate net return assumes cash flow after tax + amortization (capital reduction) divided by initial Equity, while the capitalization rate is simply net operating income divided by total investment costs.
While none of the above factors go into the “time value of money” (such as IRR, NPV and MIRR), the underlying assumptions that go into the calculation of both are very reliable and therefore the return numbers generated by both can be used confidence that these are not distorted by problematic variables.
Investment property analysis is not rocket science and I see no reason to overcomplicate an analysis when simpler, proven metrics are easily achievable. This is especially true when using more complex return metrics (such as IRR and NPV) that can skew real returns.