Real estate investor software solutions

Internal rate of return (IRR), modified internal rate of return (MIRR), and financial management rate of return (FMRR) are three returns used when real estate investing to measure the profitability of investment property. Each method arrives at a percentage rate based upon an initial investment amount and future cash flows, and in each case (of course) the higher the better.

But as you will see the procedure for making the calculation varies significantly as do the results. So you might want to rethink which measurement you prefer to rely on when making a real estate investment.

IRR

By definition internal rate of return is the discount rate at which the present value of all future cash flows is exactly equal to the initial capital investment.

To make the calculation, negative cash flows are discounted at the same rate (i.e., the IRR) as positive cash flows. Let's consider the following investment with the initial investment as CF0 (always a negative number because it is cash outflow) and five subsequent cash flows as CF1, CF2, etc. with some negative and some positive.

CF0 -10,000
CF1 -100,000
CF2 50,000
CF3 -60,000
CF4 50,000
CF5 249,300

IRR = 30%

Seems all well and good. But the problem here is that the calculation assumes that the cash generated during an investment will be reinvested at the rate calculated by the IRR (which may be unrealistically high and therefore will overstate the return on initial investment).

Likewise, since negative cash flows are also discounted at the IRR, if that rate is fairly high the investor might not accurately estimate the cash required to meet those future negative flows.

MIRR

To deal with this shortcoming many real estate analysts use a method known as MIRR (i.e., modified internal rate of return).

In this approach, the assumption is that positive cash flows the investment generates during its life can be reinvested and earns interest at a "reinvestment rate", and negative cash flows must be financed at a "finance rate" during the life of the investment.

In other words, rather than simply using one rate (i.e., IRR) to deal with both negative and positive flows, MIRR introduces the option to use two different rates. So let's make the calculation with these two rates for the same set of numbers as our investment criteria above using a finance rate of 5% and a reinvestment rate of 10%.

MIRR = 18.75%

FMRR

Okay, then along came the financial management rate of return (or FMRR). Though it also provides two separate rates to deal with negative and positive cash flows known as the "safe rate" and "reinvestment rate" utilized by MIRR, FMRR takes it a step further.

The assumption here is that where possible all future outflows are removed by using prior inflows.

That is, negative flows are discounted back at the safe rate and are either reduced or eliminated by any positive cash flow that it encounters and then any remaining positive flows are compounded forward at the reinvestment rate.

We'll use exactly the same cash flow criteria, safe rate, and reinvestment rate for our calculation as we did for MIRR but this time we'll also include a table to show you how FMRR adjusts the flows to create the return.

CF0 -111,717
CF1 0
CF2 0
CF3 0
CF4 0
CF5 304,300

FMRR = 22.19%

Conclusion

The financial management rate of return is the best measurement of profitability because it does allow for future negative cash flows to be offset by positive cash flows (which makes better sense). You probably have never heard about it because financial management rate of return is difficult to compute.

So You Know

ProAPOD® does compute FMMR in our Executive 10 real estate investing software solution and our real estate calculator. Learn more at www.proapod.com

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