What IRR, MIRR and FMRR Each Provide to Real Estate Investors
IRR, MIRR, and FMMR are acronyms for rates of return associated with real estate investing.
Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR), and Financial Management Rate of Return (FMRR) are each mathematical formulations designed to measure the profitability of a real estate investment.
All three rates of return share a similar model. They each account for the time value of money and thereby provide a linkage between the investor’s initial cash investment and the present and future value of any benefit stream derived from the investment.
In other words, all three methods are designed to show the real estate investor what might be the rate of return on their investment. But as you will see, the procedure for making each of the calculations varies significantly, as do the results.
By definition internal rate of return is the discount rate at which the present value of all future cash flows produced by an income-producing property is exactly equal to the real estate investor’s initial capital investment.
All projected future cash flows, both negative and positive, are discounted at the same rate; which, in this case, is the IRR.
CF0 -105,222 (equity)
CF6 12,780 + 169,408 (sale)
IRR = 30%
In other words, at a discount rate of 30%, the total present value for the amounts in CF1 through CF6 will equal the amount in CF0.
Some argue, however, that the internal rate of return falls short because it is not reasonable to assume periodic annual cash flows are reinvested at the IRR, or that the investor will have to cover negative cash flows at the IRR. The model does not adequately enable meaningful comparisons between two investments of differing size.
To deal with this shortcoming, the two methods discussed below, MIRR (i.e., a modified internal rate of return) and FMRR (i.e., more modification), each introduce the option to use additional rates as possible solutions.
This approach makes the assumption that negative cash flows generated during the life of the investment would be financed at a "finance rate", and positive cash flows can be reinvested and earning interest at a "reinvestment rate".
Step 1: All cash outflows are discounted to present value at the finance rate
Step 2: All cash inflows are compounded to future value at the reinvestment rate
Step 3: Find the internal rate of return to finish the computation.
For example, if we discount the outflows at 5% and compound the inflows at 10%, this is where we find the IRR to calculate MIRR.
MIRR = 14.19%
The financial management rate of return goes a step further and was developed to address the length of investment term and risk of reinvestment. It does this by extending the reinvestment rate assumption introduced in MIRR to include two different rates.
A safe rate assumed to be available for funds to service periodic negative cash flows.
A reinvestment rate that one might expect to receive from average investments of intermediate duration.
FMRR also differs from MIRR in that it makes the additional assumption that where possible all future negative cash outflows will be removed by prior positive cash inflows.
Step 1: All negative flows are discounted back at the safe rate and are either reduced or eliminated by any prior positive cash flow. Along the way, if the negatives are not eliminated completely, they are discounted back to present value and added to the initial investment.
Step 2: Any remaining positive flows are then compounded forward at the reinvestment rate to their future value and added to the expected sales proceeds if any.
Step 3: Find the internal rate of return to determine the financial management rate of return.
For example, if we again discount outflows at 5% and compound inflows at 10% using this model, this is where we find IRR to calculate FMRR.
FMRR = 14.30%
So You Know