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Alternatives to IRR and NPV
In a previous article, I discussed the shortcomings associated with using the Internal Rate of Return (IRR) or the Net Present Value (NPV) as a way to return income to generate real estate assets.
In that article, I also pointed out that there are many other return methods that I prefer and those will be the topic of discussion here. Please note that these measurements are not perfect, but in my experience, I have found them to be stronger and more reliable indicators than IRR or NPV.
As explained in my previous article, the main flaw of the IRR is that it assumes that any cash outflows will be reinvested at the same rate as the IRR. As this is rarely the case, IRR figures are often skewed, sometimes significantly so.
The Internal Rate of Return (MIRR) mitigates this problem by assuming that the present value of cash outflows is calculated using the rate of return, while the future value of cash inflows is calculated using the rate of return.
Without getting too technical, the formula used to calculate MIRR can be defined 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 times.
Calculations like the one above can be solved by simply using the MIRR formula found in Excel. In the case where cash flow is reported in cells A2 to A8, using a reinvestment rate of 7.0% and a financing rate of 5.0%, the formula will be as follows: = MIRR (A2: A8, 0.05, 0.07)
However, for this formula to work, there must be at least one negative cash flow. In cases where there are no negative cashflows, the “long-hand” formula above should be used.
In fact, the MIRR formula is a geometric mean, similar to the formula used to calculate the average growth rate of rapidly increasing numbers, such as compound interest income.
As most real estate investments (hopefully) do not have negative cash flow periods, the above calculations can be difficult, especially in cases involving investment horizons that span multiple time periods. However, since the final calculation will be more accurate than a similar IRR figure, it is worth the extra time to build it.
There are two other investment metrics that I rely on, perhaps more than any other. This includes the Yield on Equity and that old standby, the Capital Rate. If you’re reading this article, chances are you’re familiar with both metrics, but in case you’re not, the formula used to calculate the Yield is after Tax Funds + Amortization (Reduction of Principal) divided by First Equity, while the Capitalization Rate is just Gross Operating Income divided by for Total Investment Cost.
While there is nothing above the “time value of money” (such as IRR, NPV and MIRR), the basic assumptions that go into the calculation of both are very reliable, and therefore, the generated return figures can be used to be confident that these are not distorted by problematic variables.
Real estate investment analysis is not rocket science, and I see no reason to simplify the analysis, when simple, time-proven metrics are readily available. This is especially true when using complex return metrics (ie IRR and NPV) that can distort true returns.
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