@Llewelyn A.
Good Dicussion.
I really don't see a difference in RoR and IRR as you have presented them. IRR is a great metric to evaluate competing investment opportunities. IRR does this by examining the effect of time on the value of cash outlay so timing is everything. In an inflationary environment, the quicker you receive cash the more valuable it is. The more valuable it is the higher the IRR.
I agree with you that CoCR is not a viable metric because it's calculated year by year therefore ignores the time value of money. As shown by your analysis, the effect of time on the cashflow has impaired the IRR/Rate or Return by 3.58% (i.e. 10.01% - 6.43%). Pretty significant!!
Another illustration of the effect of time on cashflow is with respect to the IRR of 6.43% vs IRR of 9.13% that you calculated above. As you have stated, the correct one is the IRR of 6.43%. The "normal" IRR of 9.13% is higher because the timing of the cash outlay has been altered. By listing all the annual cashflow of $3,004 on Column V, the IRR formula assumes that those $3,004 payments are actually made which is contrary to your assumption that no cash payments are made until year 10. In both cases the total cash received is the same, $55,967, but the IRR formula recognizes that it is MORE valuable to receive $55,967 by getting $3,004 every year and $28,930 in year 10 THAN to receive a lump sum of $55,967 all in year 10. It is more valuable because part of the $55,967 is received quicker. The quicker you get it the higher the value, the higher the value the higher the IRR (again assuming inflationary environment).
Also, there are tax implications at the investor level that should be considered. In some scenarios, the implications are insignificant but if you're a 1-percenter they are almost always significant... I'm not a 1-percenter... I only wish :-) Depending on who is in the White House, it's entirely possible the tax implications could tip the scale of IRRs enough to favor one class of investments over another. (i.e. the impact on IRR of the various tax treatment of dividends, capital gain, rental income, preferance deductions, etc).
Changing direction a little bit here... we have covered much about IRR or Rate of Return, and CoCr, but not so much about the other side of the coin which is "Risk", so the rest of my post invites you to go into the subject of Risk. There is a couple of mentions of Risk in this post but not nearly enough coverage given the importance of Risk analysis in selecting an investment opportunity. In fact I think Risk analysis is just as important as Return calculation. They are two sides of the same coin. Part of the reason risk is not talked about as much as Return is because, unlike Return, Risk is hard to quantify and is subjective to each investor.
Both Risk and Return form a framework which I use to make investment decisions. This framework is really just a simple Risk vs Return analysis. Investing in general is like a game, the object of which is to deploy capital into the most profitable investment opportunity. The problem is, capital is a scarce resource. Anytime you deal with scarce resources you are confronted with opportunity costs. So somehow you must come up with an effective way to determine which investment opportunity is the best to deploy your scarce capital into. Risk/Return analysis framework helps you determine the optimal balance of Risk vs Return across various investment opportunities. An optimal balance of Risk vs Return in turn minimizes opportunity costs.
When it comes to risk, there are a few concepts I think about:
INVESTMENT Risk Profile - this is the generally accepted level of risk associated with a certain group/class of investments determined by the markets. Stocks are usually riskier than mutual funds, options are usually riskier than stocks, some real estate investments are riskier than stocks or mutual funds, etc.
INVESTOR Risk Tolerance - this is a subjective, personal posture that an investor takes with respect to the different group/class of investments. Some investors feel more comfortable investing in stocks than in real estate because of prior experience of good results. Some investors got bit hard during the 2007 crash and swore off of stocks no matter how lucrative an opportunity appears to be.
INVESTOR Required Rate of Return - this is the minimum rate of return (i.e. IRR or Yield, etc) that I would accept of a particular investment class before I would invest. This Required Rate of Return can be different for a particular investment or class of investments depending on the Risk Profile of the investment and my personal Risk Tolerance.
For example, using the framework above, based on how comfortable I feel investing in the different classes of investments, and my understanding of the level of risks associated with the different classes of investments, I might decide on the following Required Rate of Returns for the various different class of investments:
- 5% Required Rate of Return for Mutual Funds
- 8% Required Rate of Return for Stocks
- 10% Required Rate of Return (i.e. IRR) for Real Estate
Consider the two scenarios below of how Risk comes into play in selecting an investment opportunity within the Risk/Return framework:
- Let's say I have an opportunity to invest in a stock with expected return of 7.5% (i.e. after researching the stock), and another opportunity in an Single Family rental with 11% CoCR, in this case I would likely invest in the Single Family rental. This is because the Rate of Return of the Single Family is higher than my Required Rate of Return. Similarly, I would not invest in the stock investment opportunity because its Rate of Return is lower than my Required Rate of Return.
- Real Estate investors may further break down real estate investment class. For example, 20% Required Rate of Return for an SFR in a high cap rate area (i.e. higher crime, etc) and 6% Required Rate of Return for a fourplex in a low cap rate area with higher income, professional tenants. In this case, if I was offered an SFR with 19% CoC and a fourplex with 7% CoC, I would invest in the fourplex, despite the much lower Rate of Return. This is because the fourplex return of 7% is higher than my Required Rate of Return for its class of investments. By the same logic, although the SFR return of 19% is much higher than the fourplex return of 7%, I would pass on it because the SFR return is lower than my Required Rate of Return for its class of investments.
This has been a rather long post but it was my intention to give "Risk" equal air time... :-)
BTW if you are using Excel, quite a while back I switched from IRR to XIRR. XIRR does everything IRR does and more... much more. Besides it's more accurate too.
Comments welcome....Immanuel
