1. Net Present Value (NPV) and
2. Modified Internal Rate of Return (MIRR).
Here‘s a question:
- A property is priced at $1.4 million and is expected to generate a yearly net cash flow of $41,200.
- Assuming no leverage, would an investor with a Desired Rate of Return of 8% be wise to invest at the current price and sell @ $1.4 million (for simplicity) 5 years later with selling costs of 1% of the sales price?
Answer:
- $1.4M is overpriced since return does not meet Desired Rate of Return of 8%.
- The Net Present Value (NPV) is -$292,212 and therefore not a wise investment.
- Even though the Net Rental Yield is 2.9%, it is a wealth decreasing investment hence I should not invest in such project. The property will not meet my expected rate of return of 8% and I should look for other options where I can get more than 8% returns or I should reduce my expected rate of return.
The 6 toughest buying decisions faced by home buyers and investors
Consider the 6 toughest buying decisions encountered by investors and home buyers:
1. If I buy when prices are falling, am I catching a 'falling knife‘?
2. If I buy when prices are rising, am I overpaying?
3. When is a good time to buy, sell or rent?
4. How do I know if I will achieve my desired Return On Investment?
5. How do I gauge asking prices from sellers?
6. How do I know a good deal from a bad one?
Tip: Price prediction is futile. Despite this, investors hope or believe that they can predict the future, or that someone else can.
Net Present Value (NPV) Defined
The NPV is a metric that can determine whether or not an investment opportunity is a smart financial decision.
NPV is the present value (PV) of all cash flows (with inflows being positive cash flows and outflows being negative).
Tip: The Net Present Value method means that money now is more valuable than money later on. Confused? Here‘s a simpler explanation: you can use money to make more money! You could run a business, or buy something now and sell it later for more, or simply put the money in the bank to earn interest.
Example 1:
A friend needs $1,000 now, and will pay you back $1,140 in a year. Is that a good investment when you can get 10% returns elsewhere? (Hypothetical example, since we know lending money to friends is never a good investment!)
Money Out - $1,000 today:
You invested $1,000 today, so Present Value (PV) = -$1,000
Money In - $1,140 next year (Future Value or FV):
Present value (PV) of $1,000 at 10% interest rate = -$1,036.36
Net amount is:
Net Present Value (NPV) = $1,036.36 - $1,000 = $36.36
So, at 10%, the investment is worth $36.36.
In other words, it is $36.36 better than a 10% investment, in terms of today's money.
Your choice of interest rate can change too.
Suppose that you are offered an investment which will pay the following cash flows at the
end of each of the next five years:
How much would you be willing to pay for this investment if your required rate of return is 12% per year? Suppose that you were offered the investment at a cost of $800. What is the NPV?
Answer: NPV is $200.18.
Since the NPV is 0, the value of this investment at $800 is a good investment as it meets your Required Rate of Return of 12%.
Suppose that you were offered the investment at a cost of $800. What is the IRR?
Answer: IRR is 19.54%
The Internal Rate of Return 19.54% > Required Rate of Return 12%. Therefore, the value of this investment at $800 is a good investment.
Putting It All Together and the Modified Internal Rate of Return (MIRR)
The Internal Rate of Return (IRR) has been a popular metric for evaluating investments for
many years — primarily due to the simplicity with which it can be interpreted. However, the
IRR suffers from a couple of flaws.
The most important flaw is that it implicitly assumes that the cash flows will be reinvested for the life of the investment at a rate that equals the IRR.
The Modified Rate of Return (MIRR) and Net Present Value (NPV) solve this problem by using an explicit reinvestment rate (i.e. bank deposits).
From the above table, suppose that you were offered the investment at a cost of $800. What is the MIRR if the reinvestment rate is 10% per year?
Answer: MIRR is 16.48%
So, we‘ve determined that our investment valued at a cost of $800 is acceptable. It has a positive NPV, the IRR is greater than our 12% required return, and the MIRR is also greater than our 12% required return.
Reinvestment Rate
The reinvestment rate refers to the annual yield at which cash flows from an investment can be reinvested.
For example: Ryan owns one rental property. After the payment of all expenses and debt
service, Ryan has cash flows of $1,000 per month, which is a 15 percent return on his
money.
The Internal Rate of Return (IRR) for this property assumes that Ryan will take his
entire $1,000 worth of cash flows per month and reinvest that money in something else at
the same 15 percent rate he is earning on the property. This reinvestment rate of 15% is
highly unlikely and unrealistic for the average investor.
A more realistic scenario: Ryan puts the $1,000 per month in a savings account earning 0.25% interest, or uses it to pay off personal expenses, such that his reinvestment rate is 0.25%.
Two realistic reinvestment rates for the average property Investor would be Bank Deposits at prevailing rates or CPF Ordinary‘account at prevailing 2.5% interest.
Concluding Comments
To conclude, all this property ―math we have learnt so far – Cap Rates, Cash-on-Cash Return, IRR, NPV and MIRR are used mutually to:
1. Assess the performance of one‘s property (value) and desired ROI;
2. Rank and choose between different properties;
3. Rank and choose between different investments.
All smart investors will do their sums before putting their hard-earned money to work.
See: Net Present Value Calculator
Tip: The Net Present Value method means that money now is more valuable than money later on. Confused? Here‘s a simpler explanation: you can use money to make more money! You could run a business, or buy something now and sell it later for more, or simply put the money in the bank to earn interest.
Example 1:
A friend needs $1,000 now, and will pay you back $1,140 in a year. Is that a good investment when you can get 10% returns elsewhere? (Hypothetical example, since we know lending money to friends is never a good investment!)
Money Out - $1,000 today:
You invested $1,000 today, so Present Value (PV) = -$1,000
Money In - $1,140 next year (Future Value or FV):
Present value (PV) of $1,000 at 10% interest rate = -$1,036.36
Net amount is:
Net Present Value (NPV) = $1,036.36 - $1,000 = $36.36
So, at 10%, the investment is worth $36.36.
In other words, it is $36.36 better than a 10% investment, in terms of today's money.
Your choice of interest rate can change too.
Suppose that you are offered an investment which will pay the following cash flows at the
end of each of the next five years:
How much would you be willing to pay for this investment if your required rate of return is 12% per year? Suppose that you were offered the investment at a cost of $800. What is the NPV?
Answer: NPV is $200.18.
Since the NPV is 0, the value of this investment at $800 is a good investment as it meets your Required Rate of Return of 12%.
Suppose that you were offered the investment at a cost of $800. What is the IRR?
Answer: IRR is 19.54%
The Internal Rate of Return 19.54% > Required Rate of Return 12%. Therefore, the value of this investment at $800 is a good investment.
Putting It All Together and the Modified Internal Rate of Return (MIRR)
The Internal Rate of Return (IRR) has been a popular metric for evaluating investments for
many years — primarily due to the simplicity with which it can be interpreted. However, the
IRR suffers from a couple of flaws.
The most important flaw is that it implicitly assumes that the cash flows will be reinvested for the life of the investment at a rate that equals the IRR.
The Modified Rate of Return (MIRR) and Net Present Value (NPV) solve this problem by using an explicit reinvestment rate (i.e. bank deposits).
| Period | Cash Flow |
| 0 | 0 |
| 1 | 100 |
| 2 | 200 |
| 3 | 300 |
| 4 | 400 |
| 5 | 500 |
From the above table, suppose that you were offered the investment at a cost of $800. What is the MIRR if the reinvestment rate is 10% per year?
Answer: MIRR is 16.48%
So, we‘ve determined that our investment valued at a cost of $800 is acceptable. It has a positive NPV, the IRR is greater than our 12% required return, and the MIRR is also greater than our 12% required return.
Reinvestment Rate
The reinvestment rate refers to the annual yield at which cash flows from an investment can be reinvested.
For example: Ryan owns one rental property. After the payment of all expenses and debt
service, Ryan has cash flows of $1,000 per month, which is a 15 percent return on his
money.
The Internal Rate of Return (IRR) for this property assumes that Ryan will take his
entire $1,000 worth of cash flows per month and reinvest that money in something else at
the same 15 percent rate he is earning on the property. This reinvestment rate of 15% is
highly unlikely and unrealistic for the average investor.
A more realistic scenario: Ryan puts the $1,000 per month in a savings account earning 0.25% interest, or uses it to pay off personal expenses, such that his reinvestment rate is 0.25%.
Two realistic reinvestment rates for the average property Investor would be Bank Deposits at prevailing rates or CPF Ordinary‘account at prevailing 2.5% interest.
Concluding Comments
To conclude, all this property ―math we have learnt so far – Cap Rates, Cash-on-Cash Return, IRR, NPV and MIRR are used mutually to:
1. Assess the performance of one‘s property (value) and desired ROI;
2. Rank and choose between different properties;
3. Rank and choose between different investments.
All smart investors will do their sums before putting their hard-earned money to work.
See: Net Present Value Calculator
Reference1: Propwise.sg, Contributor: Gerald Tay
Reference2
