Internal Rate of Return 621%

G’Day

After a very interesting meeting with a Customer the other day I thought I’d put up a post about Internal Rate of Return

I can’t present this in tables and other stylised formats so bear with me while I write this in text format.

There have been a few recent posts regarding potential for capital growth.

While it is easy to assume that we must chase capital growth even if it means suffering negative cash flow, this is not always the case when assessing a property for investment potential

We have a fine crop of new posters and there are many facets to property investing.

Capital Growth is one and Internal Rate of Return is another.

Here is a simple example I wrote up for a customer of mine and you may find it useful to use your own figures to estimate how your own investments are travelling:

The property under consideration is a twenty year old apartment about $500,000 in the Melbourne inner high density suburbs

These figures are estimates for the first investment year

The second year may eg not have any vacancy or reletting fees

Provision for Repairs & Maintenance is also a Sinking Fund provision for eventual replacement of appliances, carpets etc

Profit & Loss Statement:

Rent @ 5.2% yield = 500pw: $26,000
Allow 2 weeks Vacancy: $1,000
Gross Rent per Annum: $25,000
Less Cash Expenses:
Interest on 97%LVR Loan of $485,000 @ 6.22%: $30,167
Loan Account Keeping Fee @ $10pm: $120
Municipal & Water Rates: $1,500
Strata Corporation: $1,500
Landlord’s Insurance: $500
Agent’s Letting Fee @ 5.5%: 1,430
Property Management Fee @ 7.7%: 2,002
Phone Calls: $15
Provision for Repairs & Maintenance: $500

Total Cash Operating Expense: -$37,734
Non-Cash Amortisation Financial Expense $13,576 / 5 Years: $2,715
Non-Cash Building Depreciation Allowance eg $100,000 x 2.5%: $2,500
Total Operating Taxable Profit / Loss: -$42,949
Less Rent Revenue: $25,000
Operating Loss c/f Tax Return: -$17,949

Ordinary Income: $85,000
PAYG Tax Paid on Ordinary Income: $19,750
Ordinary Income Adjusted for Operating Loss Investment: -$17,949
Nett Taxable Income: $67,051
Tax Payable on Nett Taxable Income: $13,965
Refund / Adjustment on Tax Paid: $5,785

SUMMARY
Income relating to investment property being Rent Income plus Tax Rebate = Realised Yield 6.16%: $30,785
Cash Contribution to Investment: $37,734
Nett Cost to hold Investment (estimate first year): $6,949


INTERNAL RATE OF RETURN:

For Example: Year One
Deposit / Funds to Complete: $51,553
Nett Operating Contribution: $6,949
Total Investment: $58,502
Assume 3% Inflation $500,000: $15,000
Assume 5% Capital Growth: $25,000
Total Growth Divided by Total Contribution: $40,000 / $58,502
Unrealised Internal Rate of Return on Investment: 68%.

In Year Two:
Nett Operating Contribution: $6,949
Assume 3% Inflation $540,000: $16,200
Assume 5% Capital Growth $540,000: $27,000
Total Growth Divided by Total Contribution: $43,200 / $6,949
Unrealised Internal Rate of Return on Investment: 621%.


Average Years One and Two:
Nett Operating Contribution: $65,451
Estimated Value of Property at end of Year Two: $583,200
Total Growth Divided by Total Contribution: $83,200 / $65,451
Unrealised Average Annual Internal Rate of Return on Investment: 127%.



Even a simple, standard, property purchase can be a phenominal investment.

Don't take anything to do with your investmens for granted. Look at the deal from all angles and you may be very surprised at what is really happening behind that triple fronted cream brick veneer.

Hope this was 'interesting' and helpful to some of our newbies

Cheers
Kristine

Thanks Trogdor for the forumulas: I have edited and included a 'back of the envelope' calculation for the Two Years' Average - I leave it to others to do the detailed calculations for their own particular scenarios.

My calculations were obviously not meant to be dot perfect and the purpose of my post was to hopefully inspire others to think about the workings of their investments and to get out their calculators so now with the help of your links they will be able to calculate down to the decimal point. Thanks!
 
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Interesting post - but thats not how you calculate IRR!!! 621% isnt relevant and is very misleading, and is certainly not an "IRR".

If you want to do it properly a simple way is to use excel XIRR function, Eg:

http://office.microsoft.com/en-us/excel/HP052093411033.aspx

Put the date of each outgoing or incoming along a row (initial purchase price, stamps, and ongoing hold costs, interest, rent, etc.. and a notional sale price on a given date) and use the XIRR function. You can factor in gearing by putting in cash outlay (i.e. deposit only) on day 1, and upon sale (or assumed exit date) just put in sale proceeds less debt repayment on day n.

An IRR must always be calculated by reference to a period of time for an investment for all cashflows (initial, periodic, and exit), not a selective yearly calculation.

Some very basic simplified reading on the maths behind this:

http://en.wikipedia.org/wiki/Internal_rate_of_return
 
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In my spreadsheets I call it "Return on Funds Committed". First time I've seen it mentioned here, and I like your name better too!

I also have a running "Opportunity Cost" calculation to show what the funds committed over time would be worth today if invested in typical term deposits. I find it helps illustrates the point even better.
 
In my spreadsheets I call it "Return on Funds Committed". First time I've seen it mentioned here, and I like your name better too!

I also have a running "Opportunity Cost" calculation to show what the funds committed over time would be worth today if invested in typical term deposits. I find it helps illustrates the point even better.

That sounds very interesting, softmonkey. Do you have a little example you could splash on the thread?

Regards Jason.
 
Thanks Trogdor for the forumulas: I have edited and included a 'back of the envelope' calculation for the Two Years' Average - I leave it to others to do the detailed calculations for their own particular scenarios.

My calculations were obviously not meant to be dot perfect and the purpose of my post was to hopefully inspire others to think about the workings of their investments and to get out their calculators so now with the help of your links they will be able to calculate down to the decimal point. Thanks!

Kristine, it is still not an internal rate of return. Nothing to do with being perfect but your concept is completely wrong. The concept of internal rate of return is explained here. It is a single figure (doesn't change annually) measuring the rate of return in today's dollars of all modelled future cash flows from an investment.

If you were to include capital gains in the estimate, you need to assume a date of sale as there needs to be a cash flow - ie in twenty years time and then discount the value down to today's dollars to see the effect it has on equity employed. You also need to specify post tax or pre tax IRR.

Your example outlines a series of negative cash flows through at least the first few years where the time value of money has the most value. While I haven't got the time to run these numbers, those negative cash flows are likely to kill your IRR, as an assumed capital increase over twenty years won't be worth that much once discounted into today's dollars, compared to the equity employed - time value of money! You can only hope to make the difference between your CG assumption and inflation over that time so the model rarely looks great.

So "typical" property investing always looks tough from an IRR point of view ("why would you buy yourself a series of negative cash flows for years?") but there is more than one way of looking at the world of course...

Discounted Cash Flow modelling has a lot to answer for in fact - infrastructure investments that last hundreds of years (think Panama Canal) look like IRR dogs if they can't pay for themselves in the first twenty / thirty years as cash flows after that aren't worth anything once discounted into today's dollars. An issue that govts grapple with on a daily basis!

Hope this helps.
 
What Trogdor said plus you'd want to be careful about providing this sort of stuff to a borrower Kristine...it looks very close to financial advice.

FWIW
 
Kristine, it is still not an internal rate of return. Nothing to do with being perfect but your concept is completely wrong.

I know she was meaning well and understand what she was trying to explain, but she has zero understanding of IRR (even after her amendments). I was hoping others with a financial background would point it out.

Its a good example of too much knowledge being a dangerous thing, and the amateurish nature as "investors" of many PI's - and lack of financial understanding.

IRR has a very clear technical meaning in finance, which has been butchered above.

Its kind of like calling a brick veneer wall a weatherboard wall, then saying "you get the point, they all are walls, they keep the wind out"!!

Again, sorry to point this out, and she was just trying to help others (a good thing), so that should be commended for her great posts, but its seems as a broker newbies look up to what she says on matters financial as "gospel" which in this instance at least should be discouraged.
 
I've never calculated IRR on my IP's before!

What is the relevance of it?

Not that much to be honest for a negatively geared IPs which you never sell as was pointed out above.

IRR is a tool used to calculate returns for private equity type deals, or for individuals, you could use it for share trades (i.e. several years) or developments.

I.e. you put in initial funds, receive periodic cashflows (usually positive, but could also be negative), then on a pre-determined date X the cashflow you expect to receive upon exit of the investment.

The IRR then gives the discount rate you would need to apply to each of those cashflow such that their NPV today is equal to zero.

In this manner you can compare different investment propositions with different cashflow profiles and exit dates against each other to see if they meet your benchmark return requirements.

As HiEquity pointed out if you did this for a normal IP properly the IRR would be quite low for a negatively geared long term hold (especially once your factored in stamp duty, sale costs, tax, etc.. - which by the way - none of these exit costs have been included above).
 
Amazing that Somers' PIA software hasn't been given a look in here.....changing IRR and all.

Below is PIA output as best as I can interpret in 5 mins, the stuff above.

irr.gif
 
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Not that much to be honest for a negatively geared IPs which you never sell as was pointed out above.

IRR is a tool used to calculate returns for private equity type deals, or for individuals, you could use it for share trades (i.e. several years) or developments.

I.e. you put in initial funds, receive periodic cashflows (usually positive, but could also be negative), then on a pre-determined date X the cashflow you expect to receive upon exit of the investment.

The IRR then gives the discount rate you would need to apply to each of those cashflow such that their NPV today is equal to zero.

In this manner you can compare different investment propositions with different cashflow profiles and exit dates against each other to see if they meet your benchmark return requirements.

As HiEquity pointed out if you did this for a normal IP properly the IRR would be quite low for a negatively geared long term hold (especially once your factored in stamp duty, sale costs, tax, etc.. - which by the way - none of these exit costs have been included above).

Agree with this, but will add that for in investment that has a series of positive and negative after tax cash flows, it is better to use a Modified Internal Rate of Return, as if you calulate a standard IRR, you will come up with more than one answer. Also, the MIRR assumes that reinvestment of funds will be at your weighted average cost of capital, which is a much more realistic scenario.

Boods
 
Amazing that Somers' PIA software hasn't been given a look in here.....changing IRR and all.

Below is PIA output as best as I can interpret in 5 mins, the stuff above.

Interesting - I haven't seen this software so can't comment on detail and therefore also don't know if the IRRs shown are correct.

However, the "changing IRR" would be perfectly legitimate if it was an analysis of different cases for sale dates. eg "What would the IRR be if I sold in year one? Year two? Year ten?" etc. There is only one IRR for each case - it doesn't actually "change" year to year.

What I can say is attempting to do an IRR on equity growth without a sale is not a legitimate use of the tool. Cash has to flow so you can only calculate an IRR if you assume a sale date, however far into the future that may be. So one half of the table is not an "IRR" however it is still a concept worth noting about transaction costs.

By the way, does anyone notice here that using this "typical" RIP example and (pretty reasonable) assumptions, if you churn properties every five years you can enjoy 30%+ returns but if you keep them for 25 years your returns are sub 20%? Does that make sense? Hands up if you know the trick to that question! :)
 
However, the "changing IRR" would be perfectly legitimate if it was an analysis of different cases for sale dates. eg "What would the IRR be if I sold in year one? Year two? Year ten?" etc. There is only one IRR for each case - it doesn't actually "change" year to year.

IRR is a rate 'pa' .....so yes for one scenario the rate can't change from year to year, as the rate is the per annum return for all years. But it is quite legitimate to compare selling in year one with selling in year 2,3,4, or 5.



What I can say is attempting to do an IRR on equity growth without a sale is not a legitimate use of the tool. Cash has to flow so you can only calculate an IRR if you assume a sale date, however far into the future that may be. So one half of the table is not an "IRR" however it is still a concept worth noting about transaction costs.

By the way, does anyone notice here that using this "typical" RIP example and (pretty reasonable) assumptions, if you churn properties every five years you can enjoy 30%+ returns but if you keep them for 25 years your returns are sub 20%? Does that make sense? Hands up if you know the trick to that question! :)

I thought this interesting when I first saw an IRR curve. In fact, I recall all investment properties have a similar IRR 30 years down the track, no matter whether they were a strong or weak buy originally.

I think I put it down to the increasingly discounted value of money the further into the future you go. So the stronger +CF of a property in later years doesn't impact growth as much as what happens in the earlier years when CF is discounted less so.

Of course, the trick is that you wouldn't be better off buying and selling a house every 5 years, for 30 years, rather than holding on to one for 30. It isn't just the in/outs that would get you. One only seems to be doing better because they keep moving forward 5 years the start date of the discount period. You have to discount all dollars back to the start of the 30 year period.
 
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Hi all,

The more I have delved into NPV, DCF, NPV of investments the less I like them.

There are just too many assumptions built into any model of the future.

WW highlights this point,

increasingly discounted value of money the further into the future you go.

that immediately assumes inflation and not deflation.

Also I have not seen any of these forward projections for propositions (from years past) come to anything like what the model/formula spat out, the future is simply too unpredictable to come close to inputing the right (or even half right) parameters.

The errors in the initial assumptions make a 'comparison' between investments worthless by any of these 'models'

bye
 
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