Alternatives to the IRR and the VAN

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 subject of discussion here. Note that these measures are not perfect, but in my experience, I have found them to be 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 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 โ€‹โ€‹of cash outflows are calculated using the financing rate, while the future value of cash inflows is 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 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 above can be circumvented simply by using the MIRR formula found in Excel. For a case where 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: =MIRR (A2 :A8, 0.05, 0.07)

However, for this formula to work, there must be at least one negative cash outflow. For instances 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 figures that increase exponentially, 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 time periods. Still, since the final calculation will likely be more accurate than a similar IRR figure, it’s worth the extra time to build it.

There are two other investment measures that I trust, perhaps more than any other. These include net return on equity and that old standby, the cap rate. If you’re reading this article, you’re probably pretty familiar with both metrics, but in case you’re not, the formula used to calculate net return assumes after-tax cash flow + amortization (reduction in principal) divided by the initial capital, while the Capitalization Rate is simply the Net Operating Income divided by the Total Cost of Investment.

While none of the above factors influence the “time value of money” (such as IRR, NPV, and MIRR), the underlying assumptions that go into calculating both are highly reliable and, as such, the figures Performance data generated by either 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 are readily available. This is especially true when using more complex performance measures (ie IRR and NPV) that can distort actual returns.

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