Alternatives to IRR and NPV
In a previous article, I discussed the shortcomings associated with using the Internal Rate of Return (IRR) or Net Present Value (NPV) as a measure of return for income-producing real estate assets.
In that article, I also indicated that there are several other return measures that I prefer and those will be the topic of discussion here. Note that these measurements are not perfect, but in my experience, I have found that they are stronger and more reliable indicators than IRR or NPV.
As detailed in my previous article, the main shortcoming of the IRR is that it assumes that any positive cash outflow will be reinvested at the same rate as the IRR. As this is rarely the case, IRR figures are often distorted, sometimes significantly.
The Modified Internal Rate of Return (MIRR) alleviates this problem by assuming that the present values of cash outflows are calculated using the financing rate, while the future value of cash inflows is calculated using the actual reinvestment rate.
Without being too technical, the formula used to calculate the MIRR can be described as “The nth root of the future value of the positive cash flows divided by the present value of the negative cash flows minus 1.0, where” n “is the number of time periods.
Calculations like the one above can be bypassed simply by using the MIRR formula found in Excel. For a case in which the cash flows are detailed in cells A2 to A8, using a reinvestment rate of 7.0% and a financing rate of 5.0%, the formula would be as follows: = 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 should be used.
In essence, the MIRR formula is simply a geometric mean, identical to the formula used to calculate the cumulative average growth rate for exponentially increasing figures, such as compound interest earnings.
Since many real estate investments (hopefully) do not experience periods of negative cash outflows, the above calculation can be cumbersome, especially in situations that include an investment horizon that covers many periods of time. Regardless, since the final calculation will likely be more accurate than a similar IRR figure, it is well worth the additional time to build.
There are two other investment measures that I trust, perhaps more than any other. These include the net return on equity and that ancient resource, the capitalization rate. If you are reading this article, you are probably quite familiar with both metrics, but in case you are not, the formula used to calculate net return assumes after tax cash flow + amortization (capital reduction) divided by the initial capital, while the capitalization rate is simply the net operating income divided by the total investment cost.
While none of the above factors in the “time value of money” (such as the IRR, NPV, and MIRR), the underlying assumptions that go into calculating both are very reliable and, as such, the figures of Performance generated by any of them can be used with the confidence that they are not distorted by problematic variables.
Investment real estate analysis is not rocket science, and I see no reason to overcomplicate an analysis, when simpler, time-tested metrics can easily be obtained. This is especially true when using more complex performance measures (ie IRR and NPV) that can distort actual returns.