To measure the profitability of an investment relative to other investments, you should know how to calculate modified internal rate of return.
Table of Contents
- Understanding the Internal Rate of Return (IRR)
- What Is the Modified Internal Rate of Return?
- How to Calculate Modified Internal Rate of Return
- Why Is MIRR Important to Real Estate Investors?
- Benefits of Using MIRR
- Things to Consider When Using MIRR
- Calculate Your ROI With the Help of Mashvisor
Real estate is one of the hottest investments in 2022. Despite the pandemic, most real estate markets in the United States are seeing a surge in demand while inventory remains tight. Competition among buyers and real estate investors is becoming more intense, resulting in fast-growing appreciation rates.
Because of the continuously increasing home values, many homebuyers are priced out of the market and are forced to rent instead. It is why many investors want to buy a rental property investment to take advantage of the rising demand for rentals.
However, not all income properties come with the same profitability potential. That is why it’s crucial to do your research thoroughly and conduct a comprehensive analysis before buying a particular investment property. But how will you know if a rental property is appealing or not?
Some investors use the modified internal rate of return as a financial measure to determine if an investment is attractive. Being able to calculate modified internal rate of return can also help you compare the viability of different investment properties.
Understanding the Internal Rate of Return (IRR)
Internal rate of return, or IRR, is a financial metric used to analyze the future value of an investment property to determine its profitability. It measures the average annual rate of return that investors have realized or expect to generate from a real estate investment. The IRR value is expressed as a percentage, and investors use it to determine the potential future returns of an investment.
To calculate the IRR, the net present value of the cash flows from an investment is set to zero and the profitability index is set to one. It is used in a discounted cash flow (DCF) analysis to help investors decide whether to proceed with an investment or not. The discounted cash flow technique is used when you measure an investment’s profitability using IRR. The DCF technique considers all projected cash flows and the time value of money.
If an investment property comes with a higher projected IRR, it means it can generate more net cash flows to exceed the cost of capital. As a general rule, the higher the IRR, the more profitable an investment will be. In real estate investing, investors who use the IRR method to compare several investment properties would typically choose the one with the highest IRR.
Limitations of Using IRR
Calculating the internal rate of return is not usually done manually. Investors use an internal rate of return calculator to determine the IRR of certain investments. However, while the internal rate of return method is popular among business managers and investors, it comes with certain limitations that can lead to inaccurate measurement.
Here are the common disadvantages of using IRR to determine a real estate investment’s potential profitability:
- Overstates the potential profits of an investment: IRR tends to overstate the potential profitability of an investment property because of its exceedingly optimistic estimate. It can lead to mistakes in capital budgeting.
- Does not consider the investment size: Using the IRR method ignores the size of an investment because it only compares cash flows to the amount of capital. Also, it is presented as a percentage and does not give you the amount of returns in terms of dollars. Larger investments with lower yields but higher cash proceeds may be viewed as unattractive compared to smaller projects with higher yields in terms of percentage.
- Does not consider the future expenses of an investment: IRR only calculates the projected cash flows based on the capital. It does not consider the possible future costs, which may affect the income generated from the investment. In addition, IRR does not consider inflation, which is a significant factor that can affect an investment’s profitability.
- Assumes that you will reinvest all cash flows at the same rate: IRR assumes that all future cash flows will be reinvested at the same rate as the IRR. It infers that the initial cash investment and subsequent cash inflows have the same earning potential. For example, if an investment property shows an IRR of 15%, you can also expect to earn an average annual return of 15%.
What Is the Modified Internal Rate of Return?
Since IRR may not be the most accurate method to measure the potential profitability of an investment property, many investors prefer to use the MIRR or the modified rate of return method. But before we discuss how to calculate the MIRR, we first need to define modified internal rate of return and understand how it works.
Modified internal rate of return, or MIRR, is a metric used to measure how appealing an investment property is. It is also used to compare several investment properties to help you decide which one will be worth your time and money. The MIRR is a modified version of the internal rate of return, which was adjusted to resolve issues associated with the IRR method.
Investors prefer to calculate modified internal rate of return to achieve a more accurate computation and assessment of the investment properties’ profitability. The MIRR method is a better option especially if you’re planning to reinvest your earnings from one investment property into other income properties.
The Difference Between IRR and MIRR
Both internal rate of return and modified internal rate of return aim to calculate the rate of returns of different investments. Both financial measures can help investors decide which investment property will be most profitable.
The IRR method considers internal factors, such as the cash flows of a property, but it excludes the cost of capital and inflation. In contrast, MIRR considers both capital and financing costs. Also, MIRR is best used to rank various investment properties of equal size.
With IRR calculations, the net present value (NPV) is equal to zero. The assumption of IRR is that the cash flows are reinvested at the same rate (which is the IRR). With MIRR computations, on the other hand, the NPV of cash inflows is equal to the outflow. The assumption of MIRR is that the cash flows are reinvested at the cost of capital. In general, IRR calculations provide a low accuracy compared to using the MIRR method.
Why Is MIRR Better Than IRR?
The concept of the internal rate of return calculation is based on the assumption that the annual cash flow will be reinvested at the same rate. If the IRR of a property is 10%, you are also assuming that you will earn an annual return of 10% if you buy that investment. It results in an overstatement of the financial return especially if you are analyzing a property that generates significant cash flow, regardless of the project size.
On the other hand, the modified internal rate of return lets you input a different rate for the property’s annual cash flow. Typically, a bank or savings rate is used. When you calculate modified internal rate of return to assess an investment’s potential, you will more likely get a realistic rate. The profitability assessment provided by the IRR may not be realistic because you can only seldom reinvest the cash flow at the same rate.
How to Calculate Modified Internal Rate of Return
Typically, investors use a modified internal rate of return calculator to calculate MIRR. The calculation is not usually done manually. However, for the sake of understanding how to calculate modified internal rate of return, we will discuss the key components involved and how the formula works.
To calculate the MIRR, you need to consider three important variables:
- FVCF: The future value of positive cash flows discounted at the reinvestment rate, which is the cost of capital
- PVCF: The present value of negative cash flows discounted at the financing rate, which is the cost of financing
- n: The number of periods
The reinvestment rate refers to the interest rate that you can earn on cash during the life of an investment property. The finance rate refers to the annual interest rate of the loan and the additional capital used to cover the negative cash flows incurred.
The MIRR formula is expressed as:
MIRR = (FVCF / PVCF)^(1/n) – 1
Steps Involved to Calculate Modified Internal Rate of Return
While the MIRR formula looks complicated, you can easily understand how it works by breaking the computation process. Here are the steps that will guide you when using the MIRR method as a real estate investment tool:
Step 1: Find Out the Financing Cost
The first step is to determine the financing cost or finance rate. It is the cost of the loan’s annual interest rate. It should also include any additional capital used to cover the negative cash flows incurred during the life of your investment. Then, discount all the negative cash flows at the finance rate and add them.
Step 2: Determine the Capital Cost
The next step is to find out the capital cost or reinvestment rate. It refers to the rate of earnings from an investment property during its life. You should then compound all the positive cash flows at the reinvestment rate or capital cost and add them.
Step 3: Determine the Future Cash Inflows
Determine the initial cash outlay on year 0 and the future cash inflow at the end of the life of an investment. Assume all the cash flows between year 0 and the end year as zero.
Step 4: Calculate the MIRR
Using the MIRR formula or an MIRR calculator, you can calculate modified internal rate of return.
Keep in mind that the manual calculation of the MIRR using the formula can be a tedious process, and it is generally prone to errors. Aside from using a modified internal rate of return financial calculator, you can also calculate MIRR easily using spreadsheet applications like Google Spreadsheet or Microsoft Excel.
In MS Excel, you can calculate modified internal rate of return using the following function: =MIRR (cash flows, financing rate, reinvestment rate)
Why Is MIRR Important to Real Estate Investors?
MIRR is a great financial measure and profitability assessment tool that can help you make informed decisions when investing in real estate market. By understanding how to calculate modified internal rate of return, you will be in a better position when it comes to choosing which real estate property to invest in. MIRR can also help you determine how much to offer for a particular income property to maximize its profit potential.
Using the MIRR calculator to perform rental property analysis can also help you better understand the possible future cash flows you can earn from the investment. This way, you can make the appropriate business proposals and investment presentations to lenders, bankers, investors, and other prospective business partners.
Benefits of Using MIRR
Using MIRR to evaluate different investment properties of equal sizes can help you understand the profit potential of each investment. It can also provide a more accurate rate of return because it is based on the cost of capital and the financing rate. In general, MIRR solves the major limitations of using the IRR method.
MIRR can help eliminate the problem of generating multiple IRRs, which usually happens with investments with unusual timing of cash flows. Also, it solves the issue of getting the same reinvestment rate because MIRR considers the cost of capital and not just the cash flows. By including the variations in the capital cost, MIRR can provide a more accurate computation for an investment’s rate of return compared to IRR.
Things to Consider When Using MIRR
While the modified internal rate of return provides a more realistic assessment compared to the internal rate of return, using MIRR comes with certain limitations, too. Here are the things that you need to be aware of when you calculate modified internal rate of return to make an investment decision:
- Cost of capital: With MIRR, you need to compute an estimate of the cost of capital. The calculation is usually subjective and can vary based on your reinvestment rate assumptions.
- Financing rate: MIRR also requires you to determine the financing rate of an investment. The financing rate can be easy to determine if it only refers to the interest rate of a loan. However, it should also include the annual interest rate that you would pay to cover the investment’s negative cash flows. The calculation can also vary based on different assumptions made, which can affect the result of the computation.
- Not recommended to assess several investment options: MIRR does not provide absolute computations on the various effects of different investments. As a result, it may not provide the optimal assessment to help investors maximize the value of different investment properties. It is especially true when an investor tries to assess several investment options at once.
- Difficult to understand: MIRR may not be the best option to use if you lack sufficient financial background. Fortunately, however, you can find a modified internal rate of return calculator online. It allows real estate investors who are not very privy to accounting to easily calculate an investment property’s MIRR.
Calculate Your ROI With the Help of Mashvisor
Due to the rising demand for rentals, real estate investing opens several opportunities for both new and experienced investors. However, not all real estate investments can provide the same potential for profit. If you decide to invest in real estate, make sure to choose a good location that is optimal for your chosen real estate strategy.
When comparing various investment properties, you can calculate modified internal rate of return of the properties to determine which one will be most profitable. You can find a modified internal rate of return calculator online to help you achieve accurate computation. However, if you’re not sure how to make a precise analysis based on your calculations, you can rely on Mashvisor to help you make an informed decision.
Mashvisor is a one-stop real estate analytics platform that provides all the necessary tools to help you find the best investment property. The tools include a property database, real estate analytics, and rental property calculator.
For starters, Mashvisor’s database contains thousands of properties from all over the United States. To find an income property, all you need to do is perform an investment property search based on your preferred city or neighborhood.
The platform can also help investors who don’t know how to invest in real estate by providing up-to-date real estate data and analytics. Once you find a property that interests you, you can click on it to see the essential property information. You will get an overview of the property’s cash on cash return, cap rate, occupancy rate, rental income, and expected expenses. You will need the said information to know how much return a property can possibly generate.
More importantly, Mashvisor can help you estimate your potential return on investment (ROI) through its rental income calculator. The calculator can help you compute your potential earnings, taking into account your expected expenses, mortgage, occupancy rate, and possible cash flows. Moreover, you can modify the figures for the expenses and customize your financing information to get a more specific calculation.
Start searching for the best investment property now. Schedule a demo to experience Mashvisor’s tools first-hand.