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Alternatives to IRR and NPV

In a previous article, I discussed the shortcomings associated with using either the Internal Rate of Return (IRR) or Net Present Value (NPV) as a return measure 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. Please note that these measures are not perfect, but in my experience, I have found them to be stronger and more reliable indicators than either IRR or NPV.

As detailed in my prior article, the primary shortcoming of the IRR is that it assumes that any positive cash outflows 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 are calculated using the actual reinvestment rate.

Without getting overly technical, the formula used to calculate the 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 sidestepped by simply using the MIRR formula found in Excel. For a case in which cash flows are detailed in cells A2 through 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 instances with no negative cashflows, the “long hand” formula above must 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.

As 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 covering many time periods. Regardless, since the final calculation will likely be more accurate than a similar IRR figure, it is worth the added time to construct it.

There are two other investment measures that I rely upon, perhaps more so than any others. These include Net Yield on Equity and that old standby, the Capitalization Rate. If you are reading this article, chances are that you are quite familiar with both metrics, but in the event that you are not, the formula used to calculate Net Yield assumes After Tax Cash Flow + Amortization (Principal Reduction) divided by Initial Equity, while the Capitalization Rate is simply Net Operating Income divided by Total Investment Cost.

While neither of the above factor in the “time value of money” (like IRR, NPV and MIRR), the underlying assumptions that go into the calculation of both are very reliable, and as such, return figures generated by either can be used with the confidence that these 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 proven metrics are readily attainable. This is especially true when using more complex return measures (i.e. the IRR and NPV) that may distort real returns.



Source by Scott A Meitus

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