Internal Rate of Return

[Kevmeister]

I was just "mucking around" with the Internal Rate of Return calculation with the contributions we have been making to our daughter's managed fund.

I just thought about how the IRR calculation would apply to a property (as much for a mental challenge as anything). My understanding of the computation is that cash inflows into the portfolio are +ve, and cash outflows from the portfolio are -ve.

From a property perspective, it seems easier to refer to "payments out of my wallet" (+ve) and "payments into my wallet" (-ve).

So, that means the initial purchase price is +ve, interest payments are +ve, all ongoing expenses are +ve

The only payments that are obviously -ve are rental income.

Then I come to the grey areas. If anyone cares to answer these I'd appreciate it:

1. How are the tax-related figures factored into the IRR? For example, depreciation, tax refunds, capital gains etc.

2. It's quite possible to compute a notional IRR and also a real IRR, depending on whether you really sell or not. For example, if you intend holding a property for 25 years, and you want to calculate the IRR after 5 years, do you compute a notional IRR (ie. you don't factor in potential selling costs like sales commision, advertising, conveyancing, capital gains tax etc) or do you?

Thanks

 

[paulzag]

IRR is the earnings rate that gives you a net present value of 0.

That is therefore theoretical looking forward and can only be truely computed on historicals.

Anyway onward and upward.

BTW PIA works it out for you.

Tax refunds are on the same side as rent.

Compute IRR for the value in 5, 7 and 10 years. Pretend you sold it for market value. You have to take selling costs into account if you are comparing across asset classes. If you a just comparing different IP's then just be consistent.

Depreciation is tricky as it is an expense and you get the refund. In doing a "business case" on an IP I'd expense the depreciation. Then I'd compare the result with leaving the depreciation cost out (but putting the tax return it). This is the same as not maintaining the car as long as it drives.

Hope this helps. Regards

Paulzag
Dreamspinner

 

[saucy gibbon]

if you are calculating an irr and including tax refunds should you also include cgt in the end period ? (note I don't include tax effect in my irr calcs, its irrelevant for comparing opportunities as I'm not trying to determine exactly what the outcome is, just which one is the best one)

 

[paulzag]

I favour being consistent. Given that tax is extremely subjective I normally do stuff pre-tax. When I use IRR it's cashflow (so cash must flow in or out) and capital growth only.

Good luck

Paulzag
Dreamspinner