Can You Have Positive Cash Flow And Negative Net Income Alternatives to IRR and NPV

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Alternatives to IRR and NPV

In a previous article, I discussed the drawbacks associated with using the internal rate of return (IRR) or net present value (NPV) as a measure of return for income-producing real estate assets.

I also stated in this article that there are several other return measures that I prefer and will be discussed here. Note that these measures are not perfect, but in my experience I have found them to be stronger and more reliable indicators than IRR or NPV.

As detailed in my previous article, the primary drawback of the IRR is that it assumes that all positive cash outflows will be reinvested at the same rate as the IRR. Since this is rarely the case, IRR numbers are often skewed, sometimes grossly so.

The modified internal rate of return (MIRR) mitigates this problem by assuming that the present values ​​of cash outflows are calculated using the financing rate, while the future value of cash inflows is calculated using the actual reinvestment rate.

Without getting too technical, the formula used to calculate the MIRR can be described as “the nth root of the future value of positive cash flows divided by the present value of negative cash flows minus 1.0, where “n” is the number of time periods.

Calculations like the one above can be avoided by simply using the MIRR formula found in Excel. For the case where the cash flows are detailed in cells A2 through A8 using a reinvestment rate of 7.0% and a financing rate of 5.0%, the formula would be: =MIRR (A2:A8, 0.05, 0, 07)

However, for this formula to work, there must be at least one negative cash outflow. For cases without negative cash flows, the above “long-arm” formula should be used.

In essence, the MIRR formula is simply a geometric mean, the same formula used to calculate the cumulative average growth rate for numbers that grow exponentially, such as interest earnings.

Since many real estate investments (hopefully) do not have periods of negative cash outflows, the above calculation can be cumbersome, especially in situations involving an investment horizon spanning many time periods. Regardless, since the final calculation is likely to be more accurate than a similar IRR value, it’s worth adding the time to put it together.

There are two other investment measures that I rely on perhaps more than any other. These include net return on equity and that old standby, the capitalization rate. If you’re reading this article, there’s a good chance you’re familiar with both metrics, but in case you’re not, the formula used to calculate net return assumes that after-tax cash flow + depreciation (decrease in principal) divided by initial equity to capital, while the capitalization rate is simply the net operating profit divided by the total cost of investment.

Although none of the above factors in the “time value of money” (such as IRR, NPV and MIRR), the underlying assumptions involved in calculating both are very reliable and as such the return values ​​produced by either can be used with confidence that these are not skewed by problematic variables.

Analyzing investment properties is not rocket science, and I see no reason to overcomplicate the analysis when simpler, time-tested metrics are readily available. This is especially true when using more complex return metrics (i.e. IRR and NPV) that can distort actual returns.

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