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Chapter 21:
Appraisal methods
of investment performance
As real estate investors often have to deal with highly complex financial situations, investors are always on the lookout for ways to make convenient and accurate comparisons between alternative investments.
Analysis of property performance using the Internal Rate of Return (IRR) can be defined as the time adjusted "average" annual return, combining cash flows from all sources and calculated on a compound interest rate. IRR allows comparison of different investments adjusted from future to present value so that using this method investments can be compared according to the timing and amount of their cash flows.
PRESENT VALUE ANALYSIS
The relatively simple process of "Present Value" analysis has been one of the time honoured methods of comparing alternative investments.
The advent of personal computers and simplified software has brought with it wider use by investors of the much more complicated internal rate of return (IRR) analysis as a tool for investment decision making. IRR is now easily arrived at via a computer spreadsheet or specialist program.
IRR can be a very useful yardstick, but like any other technique, it has its limitations. If you intend to use IRR, or have it used for you, you should know its limits.
We will compare "Present Value" and IRR and we will compare three different investments with the same IRR and show you where internal rate of return loses its usefulness.
The Value of Present Value
Typically, real estate yields vary over time. Some way must be found to adjust returns that will occur in the future so that you can measure them against cash investments that must be made now.
The first method of comparing investments is by calculating the present value of monies you would receive in the future. Present value is simply how much a given sum is worth to you sometime down the road, assuming a specified interest rate. That interest rate represents a kind of opportunity rate. It should be a rate of return available now for investments that are of comparable risk to the one that is being considered. Thus, if the opportunity rate is 8% it would discount future returns by that interest rate.
Net Present Value (NPV) is the difference between the current cash to be out laid and the discounted values of all of the proposed investment returns. If net present value is negative, one would clearly not opt for the investment you would put your money into a deal where NPV is positive.
The FLAW in Present Values
Present values and net present values have a serious flaw when it comes to making comparisons between available investments. The flaw lies in the fact that you must set that opportunity rate - a fixed rate to be used over the investment life. And, as we noted, that opportunity rate must reflect comparable risks for comparable investments. That means you fix a quantitative calculation based heavily on a qualitative judgement. In comparing two investments, a mistake or inaccuracy in the opportunity (discount) rate will lead to a distortion of present values.
For example, say you are considering one investment which offers small amounts of annual returns over the next four years, but a major gain at the end of the four years. You are comparing this with an alternative investment whose return pattern is just the opposite - substantial annual returns, but only small appreciation at the end. If you use an opportunity rate that is too low, your preference will automatically be biased in favour of the former investment. If you choose an opportunity rate that is too high, the opposite will occur - you will have a built-in bias in favour of the latter investment.
The advantages of IRR Over Present Value Analysis
That is where the internal rate of return has an advantage over present value calculations. The IRR is defined as the discount or opportunity rate that, when applied to a stream of cash inflows and outflows, makes the net present value of those flows equal to zero. In plain language, this means that you are comparing the return on one investment with the normal rate of return available elsewhere.
Every investment has an internal rate of return. Thus, in theory, you can compare alternative investments, and their proposed performances, by comparing their internal rates of return. It can be calculated by "searching" for it, applying different opportunity rates until you get an NPV equal to zero. Computers make it substantially easier. IRR is quickly printed out after you have entered your cash-in and cash-out projections. In fact, finding IRR is probably the greatest time-saver offered by the new hardware and software in terms of investment calculations. This means that more people will probably use the IRR to make investment decisions.
Comparing Three Investments
IRR is not the be-all and end-all of quantitative investment analysis. Like any measure, applied alone or in conjunction with another, the IRR has certain limitations that make its value deceptive.
To illustrate, we can show you three prospective investments, each requiring an initial outlay of $25,000. Each one offers a combination of tax shelter benefits, cash flow, and capital growth. If you are a "50%" tax bracket taxpayer, the tax losses can be valued in terms of tax savings. The table shows the proposed returns of the three alternatives.
These are obviously disparate investments. The only thing in common is the amount of initial capital required. Your first instinct might be to apply IRR analysis to see just which one offers you a greater return. But, in fact, the after tax IRR of each of the three is 19%.
THREE DIFFERENT INVESTMENTS - THE SAME IRR
| Year |
1 |
2 |
3 |
4 |
5 |
| Investment A |
|
|
|
|
|
| Initial Investment |
$25,000 |
0 |
0 |
0 |
0 |
| Cash Flow |
0 |
200 |
300 |
400 |
700 |
| Tax Benefit |
3,200 |
2,700 |
2,500 |
2,100 |
1,400 |
| Sale Proceeds |
0 |
0 |
0 |
0 |
39,409 |
| |
|
|
|
|
|
| Investment B |
|
|
|
|
|
Initial Investment
|
$25,000
|
0 |
0 |
0 |
0 |
Cash Flow
|
(400)
|
0
|
900
|
2,100
|
2,400
|
Tax Benefit
|
6,100
|
5,400
|
2,500
|
300
|
(200)
|
Sales Proceeds
|
0 |
0 |
0 |
0 |
33,233
|
| |
|
|
|
|
|
Investment C
|
|
|
|
|
|
Initial Investment
|
25,000
|
0 |
0 |
0 |
0 |
Cash Flow
|
0 |
0 |
100 |
200 |
300 |
Tax Benefit
|
1,700
|
1,200
|
900
|
300
|
0 |
Not a Matter of Indifference
The IRR does not distinguish between the various types and qualities of returns; it only works on the aggregate numbers. So, while each of the investments has exactly the same IRR, few investors would be indifferent as to which one to invest in.
For a taxpayer who already had maximum amounts of tax shelter from other sources, investment C would undoubtedly be superior, on the basis of the projections.
For someone who believes in maximising short term returns (and hence maintaining maximum return on equity at any given point), B would be best, but he may want to avoid all of them in favour of something which he can get in and out of sooner. If someone is looking for a balance, A would serve.
IRR Safely Used - In Conjunction with Good Sense
In short, IRR is a quantitative measure that can be used safely only in conjunction with other elements of your investment strategy. It is not the most sophisticated of all the quantitative tools, only perhaps, the most complicated. Simply because technology now makes it more readily accessible should not mean that it is any more applicable in your investment decisions. As you can see in the example, IRR analysis can often lead you right back to where you started - comparing investments.
We use the IRR method to assist clients to measure the full effect of our respective recommended investments. Coupled with a high level of experience, on the ground knowledge, and with extensive research it can be a formidable tool in investment decision making.
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