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## Alternatives to IRR and NPV

In a previous article, I discussed the disadvantages of using either the Internal Rate of Return (IRR) or the Net Present Value (NPV) as a measure of real estate income-producing income.

I also indicated in that article that there are several other return measures that I prefer and are discussed 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 described in my previous article, the main drawback of the IRR is that it assumes that all positive cash outflows are reinvested at the same rate as the IRR. Because this rarely happens, IRR figures are often distorted, sometimes significantly so.

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 effective reinvestment rate.

Without getting too technical, the formula used to calculate MIRR can be described as: “The so-called 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.

The above calculations can be circumvented by simply using the MIRR formula found in Excel. If the cash flows are detailed in cells A2-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, there must be at least one negative cash outflow for this formula to work. In the absence of negative cash flows, the above “long arm” formula 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 of exponentially growing figures such as compound interest income.

Since many real estate investments (hopefully) do not experience periods of negative cash flow, the above calculation can be cumbersome, especially in situations involving an investment horizon spanning many time periods. Nevertheless, since the final calculation is likely to be more accurate than a similar IRR figure, it is worth spending the extra time to prepare it.

There are two other investment measures that I rely on, perhaps more than any other. These include the net return on equity and the old standby, the capitalization rate. If you’re reading this article, chances are you’re pretty familiar with both metrics, but if you’re not, the formula used to calculate net income assumes after-tax cash flow + depreciation (reduction of fixed capital) divided by the original capital, while the capitalization rate is simply net operating income divided by the total cost of investments.

Although neither of the above factors affect the “time value of money” (like IRR, NPV, and MIRR), the assumptions underlying both calculations are highly reliable, and as such, the performance figures generated by either can be used with confidence that they are not being distorted by problematic variables.

Real estate investment analysis is not rocket science, and I see no reason to overcomplicate the analysis when simpler, time-proven metrics are easily achievable. This is especially true when using more complex return metrics (i.e. IRR and NPV) that can distort true returns.

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