Yield (Part 2) Internal Rate of Return

Measures of return such as gross rent multiplier, capitalization rate and cash-on-cash consider only the yield from incremental cash flows during the period of ownership of a property. After the first period of ownership they are no longer valid; because some of the original investment has either been received or more money has been added to the investment. These measures also overlook the value of the property. At any time during the ownership of a property, the owner has the option of selling the property and receiving a profit or loss thereon.

In the stock market, one can check the prices on a moment-to-moment basis and know the value of the stock. Real estate is not so simple. Even with an appraisal we may never be sure of the value. In order to evaluate an investment fully, projections must me made using some method concerning both income and eventual sale price. These projections are made using a mixture of science and magic. As both of the arts are inexact at best, I will leave that discussion for a day when I’ve had a few shots of tequila.

What is important is that investors do make projections in order to determine probable future yield. These projections are used to determine the internal rate of return on a property. In determining the internal rate of return the cash flows are projected and accumulated at regular intervals. The standard interval is one year. These cash flows are numbered. The initial cash flow, which is the investment amount (price) of the investment, is numbered “0” and it must be a negative number. The other cash flows are numbered consecutively. They can be positive or negative numbers. The last cash flow will include the proceeds from the sale of the hypothetical sale of the property.

The calculation of internal rate of return or “IRR” can be made using several calculators or spreadsheet programs. An email to me requesting an excel analysis template will get a useful little program for doing this calculation. What the IRR actually measures is the rate at which all cash flows discounted back to period “0” would equal “0”. If this is making your head hurt, stop reading. You can just use the template. This is done through a process called iteration. The calculator or spreadsheet “guesses” at a number and does the calculations. It adjusts the number based on whether it is too high or too low and tries again until it finds the right number.

In the next post the problems of IRR will be discussed.




David Segrest is a REALTOR in Charlotte, NC

David S. Segrest, CIPS, CCIM, TRC, CEA
david@segrestrealty.com
http://www.segrestrealty.com
Serving the world in the Carolinas, Serving the Carolinas in the World