Operating Cash Flows Investing Cash Flows And Financing Cash Flows Alternatives to IRR and NPV

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Alternatives to IRR and NPV

In a previous article, I discussed the drawbacks 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 recovery methods that I like and that will be the subject of discussion here. Please 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 primary drawback of the IRR is that any positive cash outflows are assumed to be reinvested at the same rate as the IRR. Because this is rarely the case, IRR figures are often distorted, sometimes significantly.

The modified internal rate of return (MIRR) mitigates this problem in that the present values ​​of cash outflows are calculated using the financing rate, while the future value of cash inflows is calculated using the real 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 time periods.

Calculations like the above can be done using the MIRR formula found in Excel. In cells A2 through A8 detailing cash flows 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 examples with no negative cash flow, the above “long arm” formula should be used.

In essence, the MIRR formula is simply a geometric mean, similar to the formula used to calculate the cumulative average growth rate of exponentially growing figures such as compound interest income.

Since most real estate investments (hopefully) do not experience periods of negative cash outflows, the above calculations can be complicated, especially in situations involving investment horizons covering multiple time periods. However, since the final calculation is more accurate than a similar IRR figure, it is worth the extra time to construct it.

There are two other investment strategies that I trust, perhaps more than any other. This includes the net yield on equity and that old standby, the capitalization rate. If you’re reading this article, chances are you’re very familiar with both metrics, but if you’re not, the formula used to calculate net yield assumes after-tax cash flow + amortization (principal reduction) divided by initial equity, while the capitalization rate It is simply net operating income divided by total investment costs.

While the “time value of money” (such as IRR, NPV and MIRR) does not have any of the above factors, the underlying assumptions that go into the calculation of both are very reliable, and as such, return figures generated by either can be used. Trust that these are not distorted by problematic variables.

Investing real estate analysis is not rocket science, and I see no reason to overcomplicate the analysis, when simple, time-proven metrics can be easily obtained. This is especially true when using more complex return measures (such as IRR and NPV) can distort actual returns.

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