What Is Return — Really? Ask 10 People — Get 11 Answers

Posted @ 11:40 pm - Filed under Real Estate Investing, Boise, Cash Flow, Buying Income Property, Dallas, Austin

What’s the ROI? Give me a break. If I ate a cookie every time I’ve been asked that question, I’d weigh 400 pounds. For giggles, ask your buddy exactly how he arrives at the return on an investment. Ask a few people, and as our teachers used to do, get them to show their work.

It could prove interesting.

If you’ve found a way to figure out a return on your potential investments, don’t let me talk you out of it. I wrestled with whether I should use, as illustration, a real life APOD (Annual Property Operating Data) with an attached five year after tax cash flow analysis — concluding with the number most folks love to see. You know, any number followed by a % sign. In this case, it would be called Internal Rate of Return, or IRR.

Even that high sounding approach is a lie. Cash flows by definition, are not internal, but external. Therefore, they aren’t part of IRR. Yet, they’re integral in the computation process — go figure. (Oops, I made a pun.) We don’t panic though, because there’s a very simple, and thankfully very vanilla extra step we can take to adjust perfectly for that flaw.

What’s not flawed about it? Chris in KC will be happy as a kid eatin’ pulled pork at his favorite BBQ to hear — principal pay down is automatically accounted for in this form of analysis.

Here’s what you want included in yer cypherin’ if you want a way to compare many potential investments — when you can’t buy them all.

The last one is just mean, but I threw it in there anyway.

What in the &^*%@# is Internal Rate of Return? The definition is simple.

It’s that return, which, when discounted back to Day 1, equals your initial investment.

Back in the day, when I was an expert witness in a couple civil suits a year, I was asked to define IRR almost every time my butt first hit the stand. When my answer was finished in one breath, they got very antsy.

Caveat: Ask 10 guys like me to give IRR’s definition, and you’ll get 11 answers. The cool thing though? They’ll probably all say the same thing in that many ways.

Again, don’t forget the flaw in IRR. It implied any cash flows are internal, which we know they are not. We know that because the cash flow went from the investment to our Levi’s, straight to Starbucks.

Let’s say your after tax IRR is 12%. If you have an annual cash flow of $5,000 — is it earning 12% a year? After tax? Of course it isn’t.

Hence, the flaw. It’s like a desert mirage — only it’s the return that’s not there.

It’s easily corrected though. Just assign the cash flows with what we call a ’safe rate’. (after tax) If you can take your cash flow and obtain 4% at your bank, you now can eliminate IRR’s ‘lie’ about cash flows. If we know your marginal income tax rate fed/state combined, is 35%, we can now apply an after tax rate of return to your cash flows of 2.6%.

We now initiate what’s called MIRR, M = Modified. If the analysis calls for a five year hold, we take each year’s cash flow and bring it forward at the 2.6% rate for the appropriate number of years. The last year becomes a huge cash flow, because we ’sold’ it that year — therefore all the sales proceeds land in the last year. Duh

An MIRR looks as easy as pie on a chart. It might read $XXX in year ‘0′ — then 0’s for every year until the sale year, the end of year five in this example. Year five is now $XXXX, which allows us to do a simple ’solving’ type analysis.

Initial investment = Present Value After tax sales proceeds = Future Value Time = Five Years

Just solve for ‘X’ — ‘Interest’ or ‘Return’ or Whatever the heck it pleases you to call it.

What the Modified Internal Rate of Return offers us as investors, is the ability to compare just about any investment to any other investment. Even stocks to real estate to bonds.

Apples and apples.

Any tool allowing us to compare vastly different properties as if they’re clones, (figuratively speaking) is pretty dang valuable. IRR & MIRR aren’t by any stretch of the imagination the be all end all of investment analysis — but I like ‘em.

This entry was posted on Wednesday, November 14th, 2007 at 11:40 pm and is filed under Real Estate Investing, Boise, Cash Flow, Buying Income Property, Dallas, Austin. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.