When calculating IRR...

Question

When calculating IRR should I account for equity accrual? Or do I only account for initial cash outflow and cash flows without principle pay down and appreciation?

Dion DePaoli · Answer

Just for confirmation of the above.
	
	If I make an investment say, $100 and I receive periodic payments of $10 and I hold the investment for 5 periods here is how we would look:
	
	P(0) (-$100)
	P(1) $10
	P(2) $10
	P(3) $10
	P(4) $10
	P(5) $10
	
	Clearly, the cash flow doesn't generate a profitable return since the sum of periodic payments is $50 and the investment was $100.  
	
	If P(5) was the disposition period, then the net proceeds would be added onto the cash flow.  Let's say the investment sold at the same value as purchase price, so then P(5) would be $110.  This would then have a profitable IRR.

A bond functions in a manner where you invest $100 in P(0) and get it back dollar for dollar in P(x), where x is the maturity or end of investment term.  You can arrange your model like this or you can amend the disposition number.
	
	Equity can be accounted for in the final disposition and plugged into the last period for evaluation.  Care should be taken to not count the equity twice, just for the record.  For instance, if I purchased the property for $100 and I plan on selling it for $150, then equity is already bundled up in the disposition number.  The equity accrual is realized at sale, that accrual can be from property improvement or appreciation.  So in this case, you would not go back and say the property appreciated 3% over the 5 periods.  The 3% is already rolled into the $150.
	
	A different way to approach the idea, which is all that it is, is taking the $100 property and applying the 3% appreciation to come to $103 then using that number.  This might be a conservative way of doing it, although as Giovanni mentions, most people simply add in the net proceeds at the exit period.  In this example, this would be a simply assumption that you plan to purchase the home, ride the waive of appreciation and sell based on that appreciated increase in value.  It is an assumption, just like the $150.  You will not know the actual number until it happens.
	
	In the OP, the other idea mentioned is principal (on a loan) being factored in.  This would be incorrect in any IRR.  The IRR calculation is NET cash flow.  Principal payments on loans or other types of expenses come out of the gross cash number to produce the net number.  So, if you want to plan a property with a loan, you will have to amortize the loan, go to the period where you plan to exit and payoff the principal balance of the loan from the sale proceeds to produce a net gain on sale.  That number is plugged into the period cash flow.  Three step process there.  
	
	The same principle applies to periodic cash.  Use the net number from cash between in and out monies.
	
	I would not suggest playing with MIRR unless you fully understand IRR first.

Bill Jacobsen · Answer

I would suggest that you also look at the modified IRR.  In the IRR it is assumed that cash flow received prior to the end of the cycle is able to be invested at the IRR rate, whatever it is.  With the Modified IRR cash is assumed to be invested at whatever rate you choose.  If you choose  a rate that applies to you it will result in a more acceptable number.

Good Luck.

Bill

Giovanni Isaksen · Answer

@J  Scott You are correct that the industry standard use of IRR is for measuring the complete cycle of an investment, acquisition through disposition. I have modeled long term portfolios of properties though based on pulling equity out (through refi) that was used to acquire additional properties but the IRR formula is still the same; the net cash flows positive and negative over the life of the portfolio including the initial investment and the proceeds from the final disposition.

J Scott · Answer

All money coming in and going out.

Susan Gillespie · Answer

Hi Josh, IRR is the return for cash inflows and outflows over time. Equity is realized at the sale of a property, so included with final cash inflow. Principal pay down is included in monthly cash outflows as payments are made.

IRR is so useful in evaluating income property because it incorporates the entire income stream, including start up costs, annual projected cash flows, plus proceeds from final sale – including your equity.

George Roberts · Answer

You should count only actual cash flows, not amortization (debt pay down). You will need to account for the entire debt payment (not just the interest). Be sure to count the initial cash flow (principal) as a negative.I have written an article that I believe clarifies the calculation of IRR using a spreadsheet.

Steve Morris · Answer

Forgot, CFBT = NOI - Debt Payments per period.  So CFBT does reflect the loan payments.

As far as doing CapEx, that would be a cost affecting CFBT if you don't roll it into a cash-out refi.  However, the assumption is that if you put $100K in a new roof and sell it the next day, you'd get $100K more than with the old roof so wouldn't affect your return that much.

Steve Morris · Answer

"When calculating IRR should I account for equity accrual? Or do I only account for initial cash outflow and cash flows without principle pay down and appreciation?"

All IRR reflects is the imputed return on a series of cash flows.

Example on cash flows, first year is your down pmt, then each following year is your CFBT.

The final year when you unwind and sell, your cash out will be the equity.  That would reflect price gains over the hold period and the reduction in principal owed thru amortization over the hold period.

Jaysen Medhurst · Answer

You account for mortgage pay down, but put in the year it's realized, @Josh Justiniano. I.e., when you refi or sell, same as appreciation. Don't forget Depreciation!

Roochita P. · Answer

@Giovanni Isaksen - When doing long-term IRR analysis on an investment that includes a refi, do you include the value of the cash out as a positive cash flow in your IRR calculation? Let's say you conduct 50k in rehab, get the property reappraised, do a refi and now pull money out of the property. That money you've pulled out of the property is liquid capital that you can use to re-invest, etc. - which makes me think it should be considered a positive cash flow. At the same, time it isn't really free-and-clear. It's leveraged, so you'll eventually have to pay that money back. Only when you dispose of the asset will you be able to walk away with some portion of that money. @Bill Jacobsen - Agreed on MIRR. A much more realistic measure of return depending on how you invest.

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