Part 1 of this discussion of discounted cash flow analysis, or DCF, was a general description of what it is and why it has significance for real estate investment and development. Part 2 discussed Net Present Value. Among other things, NPV provides a means of comparing alternative investment opportunities to determine which one is likely to produce the greatest value or return on dollars invested today given the investor’s desired rate of return.
Part 3 concludes the exploration of DCF with a discussion of the Internal Rate of Return, or IRR. The IRR is the discount rate at which the present worth of future cash flows is exactly equal to the capital invested. It calculates the return earned on the invested capital over the life of the investment, not just during the initial year. The IRR calculations produce a percentage, not a number. The percentage represents the return on each dollar invested from the time it was invested.
In other words, the calculation determines what percentage is necessary to discount cash flows to be produced by the investment in the future years of operation back to the time the investment is made so that the sum of those cash flows, positive and negative, equal zero.
As is true of the NPV calculations, the components of the IRR calculation are:
1. In-place (existing rents)
2. Forecasted (predicted future rent increases)*
3. Terminal or reversion (net sale proceeds)*
*These latter two are highly speculative and shouldn’t be given much weight in today’s calculations.
Most savvy investors have a hurdle rate or minimum rate of return they desire from any given investment. It generally is equal to or greater than the cost of capital. Therefore, in the IRR calculation:
· If the IRR is greater than desired rate of return, the investment is financially attractive;
· If the IRR is equal to the desired rate of return, the investor is indifferent toward the investment;
· If the IRR is less than the desired rate of return, the investment is not financially attractive;
In days long gone by, discounted cash flow analyses were performed by hand using the Ellwood Tables. It was a laborious task and one fraught with opportunities for errors. Today the calculations are easily made with the use of programmable financial calculators such as the “gold standard” hp12C, or through the use of electronic spreadsheets such as Excel.
For example, suppose an investor has an opportunity to purchase a property that requires an investment today of $750,000 and is expected to produce $100,000 per year in cash flow before taxes. Suppose also that the investor intends to sell the property after five years and expects the sale to net $1,000,000. If these numbers prove accurate, what is the rate of return that the investment will produce?
Visually, the cash flows can be expressed like this:
Cash Flow:
Today: Invested Capital = ($750,000)
Year 1: $100,000
Year 2: $100,000
Year 3: $100,000
Year 4: $100,000
Year 5: $100,000 + Proceeds of Sale: $1,000,000 = $1,100,000
Using the hp12C, the number produced is 17.99% return on the life of the investment. If this exceeds the cost of capital, the investment is attractive.
This is superior to the cash-on-cash or cap rate methods of calculating return, because they focus on a single year only. But is this method perfect? No, for one thing, it relies on assumptions. One of these is that as the cash flows are received, they are reinvested at the discount rate. If this is not the case, the IRR overstates the actual rate of return. In addition, the IRR does not consider the cost of capital involved in the investment. There is a method, the Modified Internal Rate of Return (MIRR), that does this.
Also, a potential investment indicating a higher IRR than an alternative investment actually may not be as attractive. This is because the NPV of the second potential investment may more greatly enhance the investor’s wealth that the first one.
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©2011 by The Falbey Institute for the Development of Real Estate
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