IRR Question

[mixedup]

Hi,

In an IRR calcualtion should I be including LOAN REPAYMENTS as part of the cash flow?

As an optional extra, if someone is able to highlight what value Jan Somers used in here book "More Wealth from Residential Property", on page 234 to calculate the IRR that would be great. I can't quite see which figures from which rows she must have used.

Thanks

 

[mixedup]

bump (still interested if someone knows the answer)

 

[alexlee]

Mixedup, I think you're going into analysis paralysis territory. You don't have to know how to calculate an IRR to be a successful property investor.
Alex

 

[mixedup]

I've just seen IRR in the PIA software report & I'm very curious to know how they calculated this...

What do you recommend for the questions:

Q1 - Judging how the IP investment fits into the retirement plan ==> Just use "Equity"?

Q2 - Judging whether a particular house is a good choice for investment ==> use "Yield"?

Q3 - Judging whether a particular investment strategy (e.g. house of around $XXX) is not too high a risk ==> use say LVR (loan to value) & DVR (loan payments / eligible income)?

 

[MarkB]

Fwiw, I agree with Alex re: IRR.

In fact, I'd go so far as to say that in most cases IRRs are worthless.

I've just seen IRR in the PIA software report & I'm very curious to know how they calculated this...

A detailed explanation of how IRR is calculated (and why it is calculated) can be found here.

What do you recommend for the questions...

If only it were that simple.

MU, it is case of horses for courses.

M

 

[alexlee]

I've never calculated IRR on my properties, and I certainly don't calculate it as part of my buying decision.

You know what have been the good buys, MU? The ones I actually bought, as opposed to the ones I didn't buy.

MU, don't make it too complicated. Understand the cashflow, and just buy when you can hold it for the long term.
Alex

 

[WinstonWolfe]

Alex and MB, I'll disagree that MU should carte blanche forget IRR.

I think you guys probably don't appreciate the greater sense of security you evolved in your investment strategies, by coming to understand IRR.

I'd encourage MU to come to grips with it, then eventually let it go (if he wants to). Investment analysis is a bit like learning to ride a bike...first you need the help of training wheels, then you let them go as you develop the innate sense....

MU, I'd further add that it is wise to truly understand growth and IRR, especially when growth rates are not as strong as they have been for the last 7 years. Risk adjusted returns on property could be marginal....(though what's your option?) Just remember, IRR depends on what future property value you stick in your calcs...and that's a big maybe number....

Remember the concept of risk/return when comparing investments too.
You want to build a risk premium into the % return you get from an investment with more risk and time/energy investment.

Many people I know stay away from res property because of the energy stress and time involved in sourcing properties and the trouble tenants cause. A lot easier to leverage their money in an index tracking fund with DRIP.

 

[alexlee]

I understand the concept of IRR, at least academically. I've never thought of my portfolio in that way, and I've never calculated it. IRR has never affected my investment decisions.

Each to his/her own. MU, if you want to analyse it to death, go ahead. Just remember that it doesn't mean anything if you end up analysing to much you don't buy anything.

Leveraging into an index fund and using dividend reinvestment plans is also a perfectly acceptable (and long term, most likely successful) strategy.
Alex

 

[mixedup]

thanks WW

Where I'm stuck is whether the LOAN REPAYMENTS above and beyond the interest should be treated as incoming or outgoing in the IRR calculation? For example the initial say $20,000 that one puts in for the deposit. Is this treated as an incoming to the property, or an outgoing from yourself?

Apart from this I assume rent is +ve, interest & expenses -ve, final year net equity +ve.

 

[WinstonWolfe]

thanks WW

Where I'm stuck is whether the LOAN REPAYMENTS above and beyond the interest should be treated as incoming or outgoing in the IRR calculation? For example the initial say $20,000 that one puts in for the deposit. Is this treated as an incoming to the property, or an outgoing from yourself?


If you mean you have a P&I loan, I'd include the principal component on the basis that

Even though principal is borrowed, repayment is a cash flow from your cash reserves and IRR is strictly all about cash flows. if you paid out your loan early, you'd include in IRR your final payment of principal from sale proceeds, so the same logic should be applied to paying off principal on a monthly basis.

IMHO, IRR doesn't cater for separating cash transfers into asset equity/liabilities and revenues/expenditures.

I don't consider cash going out towards paying off principal, should be considered an inwards cash flow, even though it builds your equity...

Equity is is an unrealized capital gain until you dispose of the asset. Who's to say when you sell, you'll get the value you thought you might.......just deal with the tangible cash flows as they occur...and when trying to forecast, use the after tax proceeds of your projected sale price



Apart from this I assume rent is +ve, interest & expenses -ve, final year net equity +ve.

Yup, rent is an incoming cash flow, and the other stuff outgoing....

BTW, 1 more point that is confusing....

I think PIA accounts for this by dealing with after tax cash flows, but I don't allow non cash deductions like depreciation to be considered a cash flow.

 

[MarkB]

Alex and MB, I'll disagree that MU should carte blanche forget IRR.

WW

The problem with using IRRs for property is, as you well know, that capital growth is very hard to predict.

Whether you call it an educated guess, smart buying, a gamble, whatever - when you buy an IP the CG is something you can only ever assume (that is, unless you have a pre-existing arrangement to sell at a higher price on a specific date).

So, whenever someone uses IRR, the results are heavily dependant on their mood when they plug in the figures. Optimistic = high CG and high IRR, pessimistic = lower CG and lower IRR, and so on.

IRR is extremely input sensitive and, as the following examples demonstrate (examples I have used before on this forum) an IRR tells only one small part of a much larger story - and I believe not a very important part at that.

* * *​

The following 3 cashflows each have approximately the same IRR (between 19.91 and and 20.60%), but with vastly different cash flow patterns, and net cash flow amounts.

In each case, in Year 0 the net cash flow is -$20,000 (minus $20k).

..........OPTION 1........OPTION 2......OPTION 3

Year
0..........-20,000........-20,000........-20,000
1...........1000...........15,000............0
2...........2000...........11,000............0
3...........3000..............0.................0
4...........4000..............0.................0
5...........5000..............0.................0
6...........7000..............0.................0
7...........9000..............0.................0
8...........11,000...........0.............25,000
9...........13,000...........0.............35,000
10.........15,000............0.............45,000

Net CF....$50,000......$6,000 .......$85,000

IRR.........20.24%.......20.60%.......19.91%

* * *​

I'd encourage MU to come to grips with it, then eventually let it go (if he wants to).

I agree - MU should come to terms with IRR. Dare I be so immodest to suggest that if he/she takes the time to read the posts I have made on the topic previously (link above) then they'll understand it better than 99% of investors.

Mark, you explain IRR really well.

Shame Bruce isn't around anymore to stick up for me.

M

 

[WinstonWolfe]

Shame Bruce isn't around anymore to stick up for me.

M

thefirstbruce? how much cred could a guy with a moniker like that have?

I had meant to include MU, that you won't find a more concise and clear explanation of IRR anywhere on the internet than what MarkB refers to above....believe me, I have looked.

And I agree with Mark's comments about what mood or info you use to decide what value or sale price you plug into IRR......

But disagree from the POV that there's no ideal investment comparison tool, and IRR is a pretty logical compromise.... although Excel's MIRR is supposed to be better, but the bloody thing never seems to do what it is supposed to.....

 

[redsquash]

I've just seen IRR in the PIA software report & I'm very curious to know how they calculated this...

What do you recommend for the questions:

Q1 - Judging how the IP investment fits into the retirement plan ==> Just use "Equity"?

Q2 - Judging whether a particular house is a good choice for investment ==> use "Yield"?

Q3 - Judging whether a particular investment strategy (e.g. house of around $XXX) is not too high a risk ==> use say LVR (loan to value) & DVR (loan payments / eligible income)?

You cant answer any of these questions if you want the correct answer as there are too many outside factors affecting the answer.
To me your questions are also too brief and don't make a lot of sense ,so I don't know what exactly you are driving at.
eg a yield of 1 % or 10 % wont tell me if a house is a good investment.
Capital growth could be 5 % or 50% but yield is calculated on purchase price.
If something is too high risk is a judgement call. It is up to you to interpret the figures based on the property you have in mind.
eg your LVR could be very high but future growth may also be very high. Risk is not part of the equation............again they are just figures which need to be assessed against the property in question
IRR is an excellent tool and you include any cash coming or going out in the calcs I always like to compare the return to bank intrest

 

[geoffw]

thefirstbruce? how much cred could a guy with a moniker like that have?

Probably the identical cred as a guy with the moniker WinstonWolf

 

[WinstonWolfe]

Probably the identical cred as a guy with the moniker WinstonWolf

which is more, or less, GeoffW??????????

 

[Able]

Each to their own. I to find IRR to be a very useful analysis tool. For those interested read on.

Lots of people will buy IP's for the capital growth, knowing that it will cost them each year they own the property but maybe working on a simple rule of thumb such as the property value will increase at 7% p.a. or the value will double in 10 years.

I prefer to make my assumptions and look at the IRR. I do not have the PIA software but i don't mind knocking up a spreadsheet for my analysis.

Here is a very simple example. Lets assume i buy an IP for $250k and sell in 10 years time for $500k. The net cost to me for the property each year is $4k. My purchasing costs and deposit were $40k and my proceeds from the sale (after paying out the loan, selling costs and some capital gains are $210k). IRR needs to consider ALL funds that i either inject or reap from the investment.

My cash flows for each of 10 years are:
-$44k, -$4k, -$4k, -$4k, -$4k, -$4k, -$4k, -$4k, -$4k, +$206k

IRR can be worked out with the Excel formula:
=IRR(-44,-4,-4,-4,-4,-4,-4,-4,-4,206)
=12.2%

What this means that i have earned an equivalent of 12.2% p.a. on all the money i have injected into the investment. IRR takes into account that i have injected different amounts of money at different stages throughout the 10 years.

Now if i wanted i could compare this rate of return with a rate of return I THINK i might achieve from another investment. I may compare this rate of return with what i think i can achieve with a long term share portfolio. Remember though that the above example give the rate of return after tax.

IRR is also commonly used in development. A company (or and individual) may only go ahead with a development if the feasibility shows that a certain hurdle rate of return can be exceeded. A project that runs over a number of years may show a reasonable profit margin but the timing of the expenditure and the revenue is very important. Any changes to the costs or revenue and any changes to the timing will have and impact on the IRR.

Regards
Able

 

[WinstonWolfe]

IRR is also commonly used in development. A company (or and individual) may only go ahead with a development if the feasibility shows that a certain hurdle rate of return can be exceeded. A project that runs over a number of years may show a reasonable profit margin but the timing of the expenditure and the revenue is very important. Any changes to the costs or revenue and any changes to the timing will have and impact on the IRR.

Regards
Able

Able, I haven't got an issue with anything you say.

I agree a company is going to rely on IRR or its offspin, NPV, to compare two avenues for channeling capital +/- debt serviceability.

And there's nothing like IRR to wake someone up to the superior benefits if the next level of investment, using OPM.....

But IRR's shortfall is it doesn't cater for the levelling of risk vs reward.....

 

[Able]

But IRR's shortfall is it doesn't cater for the levelling of risk vs reward.....

I totally agree. Purely comparing rates of return does not take into account the many other aspects to consider when comparing alternate investments.

 

[mixedup]

Actually, I've just found out I can perform super-annuation salary sacrifice of up to $50k / year, so I really should under the benefit of this re investing one's extra dollars. With this your $$ you invest into super is taxed at 15% instead of the marginal rate (around 40%). Guess you lose leverage here however. Perhaps IRR can assist comparing the options.

 

[alexlee]

Actually, I've just found out I can perform super-annuation salary sacrifice of up to $50k / year, so I really should under the benefit of this re investing one's extra dollars. With this your $$ you invest into super is taxed at 15% instead of the marginal rate (around 40%). Guess you lose leverage here however. Perhaps IRR can assist comparing the options.

Not just leverage. To qualify for all the super tax breaks, you lock your money away until 60 or something. It depends on your age. At 30, super isn't a very good vehicle for me because I can get rich in less than 30 years.
Alex