IRR on somersoft software

[john doe]

Hi everyone,

I've just started playing around with the somersoft investment software (the version for professional investors). I'm having difficulty understanding their explaination of IRR.

I plugged in some numbers for a negatively geared property and looked at the IRR after 10 years (with an interst only loan). In the software, they ask you

"to think of the money you are outlaying on your IP as being deposited in a bank account, with interest added each year. In this case the "deposits" are represented by the after-tax cash flows. The total amount in your "account" (including interest) at the end of the period is the equity in the IP."

SO, let's say the principal on my loan is $240k, and the value of the property is $500k in 10 years. In the somersoft software (in the detailed report), it then tells me that the total amount in my "account" at the end of 10 years is $260k (ie, the equity in the IP.

My question is....if my "deposits" into the "account" are the after-tax cash flows, which are negative in my case of a negatively geared property, then shouldn't the final amount in the "account" be the equity MINUS all of those negative after-tax cash flows after 10 years?

Why does the report state the amount in my "account" as simply being the equity, and ignores the cash flow each year?

Regarding the IRR...the software seems to suggest that the cashflow each year has been considered. But after looking at their explanation of the final amount in my "account", I'm beginning to worry that maybe it doesn't.

Can anyone shed any light?

Cheers

John

 

[strangep]

Hi John

I'm still a little fuzzy on this myself but I'll have a go at answering it anyway....

You have to think of the money you are actually outlaying to hold the property as money that's being invested, say into a bank account. You will also earn interest on that bank account which in this case takes the form of the increase in equity each year.

At the end of the period that you are looking at, say 5 years, you end up with an amount which equals the equity in your property. The IRR is the interest rate that would have to be applied to the amounts that you have invested, ie. the money you paid out to hold the property each year, to give you the equity at the end of the 5 years.

Does that make sense??

Hope it helps, even if it's just a little

Cheers

Paul

 

[john doe]

Hi Paul,

Thanks for that. Sort of makes things clearer. I think I'll just have to ponder over this a bit more.

So, is the IRR basically the compound interest rate every year that an investment makes?

John

 

[paulzag]

IRR is the Internal Rate of Return.

Basically that discount rate at which the Net Present Value (NPV) of the future cashflows is zero. That means your discounted future cashflows = your starting investment amount.

It's useful for comparing investments accross asset classes as well as comparing IP's.

But I'm not convinced it's worth the hassle for most property investors. I like it, but I'm terminally analytical.

Regards

Paulzag
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