Why do so many real estate investments fail to achieve the Internal Rate of Return (IRR) calculated or advertised?
MIRR vs. IRR
When pitching or analyzing a real estate investment, most investors will calculate the IRR of the cash flow for a given period of years, the Cash-On-Cash annual return, the expected Exit Cap Rate, and an Equity Multiplier as part of a financial review. Educated guesses are made for an exit capitalization rate on a projected NOI some years in the future. From these figures an internal rate of return is generally calculated.
Simply put, an Internal Rate of Return (IRR) is a metric that tells investors the average annual return they can expect to realize from a real estate investment over time, expressed as a percentage. It is essentially the discount rate at which the net present value of a series of cash flows (negative for initial investment, positive for cash flows) equals zero.
The fault lies in the assumption that all positive cash flows are reinvested at the project’s own rate of return. In the real world, this does not happen, and/or the opportunity to make that ongoing investment does not exist.
The XIRR (Extended Internal Rate of Return) calculation, though more accurate as it allows the analyst to time the returns more frequently than annually, fails for the same reason – the assumption that the income is reinvested at the same rate over the life of the investment.
What is MIRR?
The modified internal rate of return (MIRR) is a financial metric used to calculate the net present value (NPV) of terminal inflows to equal to the initial investment outflow. While, the IRR implies that positive cash flows are reinvested at the project's own rate of return, the MIRR allows the analyst to specify a different reinvestment rate for future cash flows.
In a situation when the modified internal rate of return is the only criterion, the decision rule is very simple: a project can be accepted if its MIRR is greater than the cost of capital and rejected if the rate is lower than the cost of capital.
To calculate MIRR, you still need an array of values from the initial capital required to enter the investment to the final exit cash flow. You also need to know the finance rate (initial cost of borrowing) and the reinvestment rate (the compounding rate of return at which positive cash flows are reinvested).
To calculate the MIRR there must be at least one negative number and one positive number, otherwise the calculation will not make sense. The cash flow should occur at regular time intervals and be presented in the correct chronological order.
The MIRR is easily calculated in Microsoft Excel:
=MIRR(value array, finance rate, reinvestment rate)
The value array is the array or cells containing your cash flows, positive and negative. The finance rate is expressed as a percentage, as is the reinvestment rate. A reinvestment rate tends to be closer to the investor’s cost of capital.
In this example, the IRR calculation returns 18.88%. but when recognizing that the reinvestment rate of the positive cash flows may not present itself at that rate, and that the reinvestment rate may only be 3.75%, the MIRR is 14.25%. It is only when the reinvestment rate equals 18.88% that the MIRR and the IRR are equal, as in the example below.
Some analysts point out that the MIRR may not yield a reliable result because a project's earnings are not always fully reinvested. If you expect the reinvestments to earn 6%, but only half of the cash flows are likely to be reinvested, use the reinvestment rate of 3% instead, or some comparable adjustment.
The takeaway here is two-fold: (1) if the reinvestment rate does not equal the IRR; or 2) if all of the cash flows are not reinvested, then MIRR can give a clearer analysis of the expected returns on an initial investment.
As MIRR is less understood, the best practice is to calculate both IRR and MIRR along with an explanation of each.