One of the most difficult parts of evaluating a real estate investment (or almost any investment) is comparing the cash flows among properties to figure out which one provides the highest return.
The reason is that investments have different cash flows with different amounts of money going out and coming in at different times. So looking at just the cash flow to try to compare the rates of return is like comparing apples and oranges.
For example, which of these two properties offers a higher rate of return:
Property A requires a down payment of $100,000. It has a first-year cash flow of $8,000, which increases annually by 3 percent for 10 years. The property then sells, netting $184,000 after paying off the mortgage and transaction costs.
Property B requires a $150,000 down payment. It has a cash flow of $12,000 the first year, which increases by $240 each of the first three years and then increases by $300 a year thereafter. The property is sold at the end of the 10th year with net sale proceeds of $250,000. (Find the answer at the end of this column.)
Fortunately, a financial tool is available to help investors figure rate of return. The tool is a calculation called Internal Rate of Return (IRR). Using IRR to determine the return from a cash flow makes possible an apples-to-apples comparison of investment opportunities.
Here is how IRR works.
If you were to invest $100 for 10 years at 5 percent interest, your investment would grow to $163. So it makes sense that $163 received in 10 years is the same as $100 today with 5 percent interest. In financial terms, the future value of $163 with 5 percent interest has a present value of $100.
Another way to look at this example is: 5 percent interest is the rate of return that makes a future value of $163 have the same present value as $100 invested today. So the investment today and the present value of the money received in the future are both $100.
But because the investment today is money going out of your pocket, it is a negative number while the $100 that is the present value of the money to be received in the future is a positive number because it is cash going into your pocket. When you add up the present value of money in the cash flow in this example there is a negative $100 investment and a positive $100 present value of the $163 received in the future. The two present value numbers cancel each other out and result in a zero sum.
IRR determines the interest rate that makes the present value of the cash flow zero. And that interest rate is the return, or yield.
This example is simple, because the cash flow has just the initial $100 investment with no cash returned until the $163 is received at the end. Most investments, especially real estate, provide cash returns throughout the life of the investment.
IRR works for those as well. IRR can determine the interest rate that makes the present value of the sum of all the cash in or out over the term of the investment equal the initial investment, taking into consideration the amount of money and timing of those returns. Computer programs such as Excel can do this almost instantly.
IRR only measures rate of return. It says nothing about factors outside the return. That is why it is called "Internal" rate of return. It says nothing about the quality of the property, the market, the tenants or anything else not associated with rate of return. IRR is just one factor among many that must be considered when evaluating investment properties.
The answer to our opening question -- which of the two properties provides the highest return -- is property A with an IRR of 13 percent compared to B with 12 percent. These properties have very different cash flows but a surprisingly similar rate of return.
Chris Stephens, CCIM, is a local associate broker specializing in commercial and investment real estate. His column appears every month in the Daily News.