If you’re wondering why we’re posting every few days- it’s so that we build up some content. After we’ve got a decent amount on this blog, we’ll slow down a bit.
Today let’s talk about Internal Rate of Return (IRR) and Net Present Value (NPV) and how they are used in real estate. If you haven’t heard of these terms or if they are very unfamiliar to you, don’t stop reading- I’m about to explain them. One comment I received is that I shouldn’t assume a basic knowledge of Real estate terms, so I’ll try to be a little more descriptive when writing out explanations. Admittedly, this is the wrong topic to try and start simplifying with, but it is vital to understanding investing in general.
The mathematical formula for Internal Rate of Return (IRR) is where IRR is r. If analyzing past performance NPV would equal $0 as it’s used more to determine initial investments into future properties. C = cash flows. Keep in mind that this is an iterative formula which means it must be run multiple times over the number of cash flows taken out which are usually summed annually to give an annual rate of return.
Okay, now that you understand and should feel comfortable using & calculating Internal Rate of Return, let’s move on to NPV. Just kidding. Calculators, Spreadsheet programs like Excel and financial softwares make them easy to run and in this article, we won’t focus on the mathematical formulas, but the why and how we would use it when analyzing a real estate investment.
To start, I need to make sure everyone has a basic knowledge of the financial term Time Value of Money, commonly written as TVM. The term may be new to some, but we all understand that if I put $100 in an investment today at an interest rate of 10%, then that money will grow and the longer I leave it in, the more it grows. The time value of money can work forward, like in the example I just gave, or backwards. The following is an example of a backwards TVM calculation. I’m 35 years old right now and want to retire when I’m 65. I estimate I will need $1,000,000 to retire comfortably. If I have $100,000 right now, what interest rate would I need to invest the $100,000 at for the next 30 years, to reach my goal of $1,000,000? Or if I was planning on investing $50,000 now and then $500/month thereafter, what interest rate would I now need to reach $1,000,000? Another question could be- if I can get 7% on my money for the next 30 years, how much should I invest either initially, monthly or both to reach my goal? The five components that can be used to solve any TVM calculation are 1. Initial Investment amount, expressed as a negative number(you’re paying it out), 2. Time (# of periods to compound) 3.Interest Rate (aka IRR) 4. Cash flows or payments 5. Future Value. If that doesn’t make sense to you, don’t worry about it, just keep reading, once you starting playing with the calculator, it will make more sense.
Before you drone out on me thinking this is just another math problem from high school algebra class, please realize that understanding the concept of TVM is key to building wealth through investing. The interest rate that you get from running similar calculations on your own situation is what we call the investor’s “Discount Rate” or required rate of return, as we have to discount from a future value (in this example it was $1M) back to today to determine what we need to invest and at what interest rate, in order to reach our goal.
If you still feel a little lost, don’t worry about it, it’s easier understood when you start running the calculations for yourself. A good way to do this is to download a “Financial” calculator either on your computer or smart phone and then just plug and play with numbers until you start to see the correlation. I would search for the Time Value of Money or TVM words along with “financial calculators”. There are plenty of free ones, so no need spend money while learning.
Next let’s move to Net Present Value (NPV), which is necessary to calculate IRR. In basic terms, NPV is how much you should pay, vs. how much they want you to pay, to achieve your “Discount Rate” aka your desired rate of return. When I say pay- this refers only to your down payment or what we call- cost of acquisition, which includes down payment and any other cost incurred that you have to pay out up front.
Let’s say that in order to reach my investment goal, I need to invest my money at 10% per year for 10 years to reach my financial goals. 10% would be my discount rate. I’m looking at a property that would require me to put as a down payment $100,000 on an interest only loan. The property puts out $8,000/ year in cash flows and at the end of the 10 years I get $120,000 from sale proceeds of the property due to appreciation. When I run this through an IRR calculator, this shows me that I’d make an 9.3% annual return. Obviously this is .7% short of my discount rate. So how much “less” would I need to invest up front, for the same cash flows to equal a 10% return on my investment? The amount of the difference between our current analysis and our “Discounted” analysis is our Net Present Value. In this example, we would need to pay $4578.27 less on our down payment ($95,421.73) in order for in order for us to make our Discount rate of 10%. Real Estate is usually a leveraged investment (we get a loan to buy it), so assuming we only put 25% of the purchase price as a down payment, we would need to ask for a reduction in the purchase price of 4 times (or divide by .25) the net present value ($18,313) in order to lower our out of pocket by the net present value of $4578.27. Now for the beginning investor, that’s going to sound complex, however that was actually a very simplified approach. Especially with real estate, if you lower the initial investment, you’ve modified the loan amount. This directly impacts the cash flows from the property as most loans are not interest only, but are amortized, meaning you’re paying down principal each month along with interest. This makes the pay out at the end larger due to principal paid down on the loan. It may also impact lender fees, etc. My goal is not to give you every consideration, but an understanding of how and why we use NPV to determine what we should be offering on a property to get an investor to their investment targets.
Some of you are probably saying, wait a minute, you just told me that we had to run the Internal Rate of Return to come up with the NPV. That’s because Internal Rate of Return and the NPV are inseparably connected. You cannot determine one without the other. In microsoft excel, it is what we would refer to as a circular reference, which has to be stopped after a number of iterations or we get an error message. If you use Microsoft’s IRR formulas, this will happen automatically. If you’re not familiar with excel, just ignore the last sentences. Some investors right now are thinking- this is wrong, because they run IRR all the time without using a discount rate. However, in every analysis, if you don’t put in a discount rate, your NPV is $0, which is why you are getting the IRR that you are. You can do this, especially when analyzing past performance on a property you currently own, but every investor should know their discount rate, unless they are super rich and no longer have any investment goals. If that’s you, I’ve got some beach front property in Pocatello I think you’d be interested in.
IRR is a great tool for measuring real estate performance because it monitors our rate of return when we have cash flows coming from a property. It is much better test for determining an income stream from investing rather than just a lump sum after a period of years. As most real estate has frequent cash flows or contributions, a simple compounding formula is impractical and not at all accurate as cash flows are not reinvested into the same investment vehicle they came from. To clarify, let’s look at two investment vehicles from banks- mortgages vs. CD’s. In a typical amortized home mortgage the bank’s IRR is the interest rate on your loan. This does not factor closing costs and points, but because a home mortgage is paid off through cash flows to the bank via your monthly mortgage payment, the payments once received are no longer compounded, which means we should use the IRR to analyze the investment. Because it doesn’t add to the balance, it’s not compounded into the return. In a CD by contrast, when we put our funds in, the interest just adds to it and then they pay interest on the original investment and the interest earned too. This is a situation where we would use simple compounding. How do we compare the two to each other to get an apples to apples approach? On the mortgage we would have to look at how the monthly payments were reinvested by the bank, then combine the IRR on the loan without the cash flows accounted for, (just the ending balance) with the IRR of the reinvested cash flows (which produce no further cash flows) and run a weighted balance to determine compound interest rate. That’s a lot of work and only is necessary when comparing apples to apples with another compound investment. If you don’t have any cash flow disbursements from a property during the period of ownership, then at the end of the term the internal rate of return and the compound interest rate would be the same. IRR is better, because it analyzes both situations correctly and assimilates compound interest where necessary.
The key to this article isn’t that you need to know perfectly how to run IRR or determine the NPV of each future investment. The key component is that each investor needs to first have a goal. From the goal, we can determine what discount rate we need to be earning and then we search for properties that perform at levels that we can reasonably achieve based on this investor’s discount rate. IRR and NPV are how we analyze the property to make sure they line up with your discount rate, not visa versa.
Want help determining your discount rate? Contact us and we’ll help you. We don’t charge for it and if it’s the right fit we’ll help you find Real Estate investments that help you reach your goals. Please note, we’re not financial planners. We’re just good with real estate analysis.
Author: Mark Bitton
http://prsidaho.com PRS, Inc. is the brokerage through which we sell investments in Idaho