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Going Beyond IRR for Projected Returns
Investors, by and large, buy real estate in hopes that this asset increases in value while providing ongoing returns. But when it comes to determining what real estate to buy, the question is how investors can – and should – compare projected returns on these assets to decide on buying or holding.
A recently released thought leadership piece by Colliers’ Marilynne Clark said that one way to evaluate alternative investments is to calculate the internal rate of return (IRR) for each. The IRR used to measure an investment’s potential profitability, results in a total return on equity during the hold period.
But here’s the issue with using just the IRR to decide which investment: It “does not reflect the potential reinvestment of the cash flow proceeds, or the cost of generating funds for any cash flow shortfalls, over the hold period,” Clark wrote. The IRR assumes that the money will be reinvested at the same time. In the real world, this is not always the case.
Two other approaches that might provide better insight into projected returns are capital accumulation and modified internal rate of return.
Capital Accumulation
Capital accumulation represents the total monetary value accumulated over an asset’s hold period. In other words, it tracks an asset’s value increase while an investor owns a particular real estate property. The formula for capital accumulation is the current value of the real estate minus the amount invested. It’s a measure of the difference between the initial investment and its current value at a specific point in time. Capital accumulation information is presented in the dollar format.
Modified Internal Rate of Return
The Modified Internal Rate of Return (MIRR) is an IRR variant. It presumes the reinvestment of positive cash flows. It also assumes the financing of capital outlays. While the IRR relies on a single expected rate of return for an asset’s cash flows, the MIRR considers anticipated growth rates and cost of capital rates, reporting them as percentages. The MIRR calculation formula is:
(positive cash flows x cost of capital)/(initial outlays x financing costs)
The More You Know . . .
Clark indicated incorporating the capital accumulation and MIRR approaches to determine real estate investment strategies by comparing “alternative investments in a way that is more in-depth than the IRR calculation alone.” Though these two methods present different results, “they do give an investor a greater insight when facing a decision on which investment to purchase,” Clark added.
- ◦Sale/Acquisition
- ◦Financing
