IRR and Underperforming Property

G'day All,

I've just completed reading "More Wealth from Residintial Property" and purchased PIA. One of the key indicators used throughout the book and by PIA is the IRR. It makes sense to use this as KPI but can not see why the current article in "The Australian property Investor" that "...it may actuually mask the harm caused by an underperforming property...". The article, "Does your property make the grade" discusses in point 2 how to evalute capital growth of your IP. Could someone please shed some light on this statement, as the article does not go into why the IRR masks the harm caused by an uderperforming property?

Thanks

Yumbi said:

I've just completed reading "More Wealth from Residintial Property" and purchased PIA. One of the key indicators used throughout the book and by PIA is the IRR. It makes sense to use this as KPI

Click to expand...

IRR is just one of several KPIs that could be used.

Personally, I don't use it.

Yumbi said:

But can not see why the current article in "The Australian property Investor" that "...it may actuually mask the harm caused by an underperforming property...". The article, "Does your property make the grade" discusses in point 2 how to evalute capital growth of your IP.

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I have not seen the article that you refer to, but I can see where API may be coming from.

Yumbi said:

Could someone please shed some light on this statement, as the article does not go into why the IRR masks the harm caused by an uderperforming property?

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It is probably worthwhile that we remind ourselves what an IRR is:

Pitt St said:

Consider a series of Cashflows.

Initially these cashflows are negative (expenses exceed income).

Then later they are positive (income exceeds expenses).

Example......

Year 1 - ($20,000) [minus $20,000]

Year 2 - $5,000

Year 3 - $7,500

Year 4 - $10,000

Year 5 - $10,000

Net Cash Flow = $12,500


Now anybody can look at that series of cashflows and ascertain that the net cash-flow is $12,500 (-20 + 5 + 7.5 + 10 + 10).

But what that simple add does not tell us how robust that future positive cashflow is.

We all know that inflation erodes the value of a future dollar.

So what the IRR does is tell you (effectively) at what rate of inflation (what discount rate) would the sum total of that series of cashflows have a Present Value (PV) of zero.

Taking the same series of cash flows (and in my case using MS Excel) we can calcuate the following:


Year 1 - ($20,000) [minus $20,000]

Year 2 - $5,000

Year 3 - $7,500

Year 4 - $10,000

Year 5 - $10,000

Net Cash Flow = $12,500

Internal Rate of Return = 20%


The IRR calculation tells us that for this particular series of cash flows, a discount rate of 20% is required to give them a PV of zero.

But inflation is not anywhere near 20% you say!

True..... but this does not mean that the IRR is any less valid.

In my last post I said that the "IRR can be used as a measure of the financial viability of a project (given financing costs). The calculated IRR can be compared to a predetermined interest rate typically based on market rates of interest. If the IRR (say, 15%) exceeds the predetermined discount rate (say, 12%), then the project is worthwhile, otherwise not."

In my little series of cashflows I have an IRR of 20%, but what it it was much lower - say 5%

Would this make the project worthwhile?

Well, CPI is currently running at 2.5% pa and the RBA does aim to keep it at between 2 - 3% over the course of the business cycle - so no problem there.

But what about financing and the opportunity cost of that money?

5% may be above what CPI will reach over the investment period, but it is less than you can get in an at-call account and it is also less than the interest rate in the overnight cash market (5.25%) - so in both those cases the investment would fail to be economically viable.

So how much is needed to make a project worthwhile?

Well, over and above CPI / the cost of finance / the opportunity cost of putting money elsewhere, it really is up to the individual investor as to how much IRR they require before an investment alternative becomes viable.

I have heard anecdotal stories that some people require a min IRR before they proceed with an investment, but each to their own.

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In the MS Excel attachment (below), the "Original Example" relates to that series of cashflows mentioned above.



In regards to the API example, consider 3 cashflows, each with approximately the same IRR (between 19.91 and and 20.60%), but with vastly different cash flow patterns, and net cash flow amounts.

In each case, in Year 0 the net cash flow is -$20,000 (minus $20k).


..........OPTION 1........OPTION 2......OPTION 3

Year
0..........-20,000........-20,000........-20,000
1...........1000...........15,000............0
2...........2000...........11,000............0
3...........3000..............0.................0
4...........4000..............0.................0
5...........5000..............0.................0
6...........7000..............0.................0
7...........9000..............0.................0
8...........11,000...........0.............25,000
9...........13,000...........0.............35,000
10.........15,000............0.............45,000

Net CF....$50,000......$6,000 .......$85,000

IRR.........20.24%.......20.60%.......19.91%



If the IRR is any indication, all 3 options are about as good as each other.

And, depending on ones individual circumstances and goals, any one of the 3 could be "best".


But to look at how IRR may mask an underperforming asset, my guess is that you need to consider the opportunity cost of the alternatives chosen.


Option 3, for example, has the highest net CF over the 10 year period, but (talking a hypothetical property here) gives you no income / capital gain to use until the 8th year.


Option 1 is nothing startling, pretty much slow and steady with a stronger trend towards the latter part of the decade. That series of cash flows / capital gains will help you sleep at night, but it will be a few years before you can use it as leverage.


Option 2 has (easily) the lowest net CF position - only +$6,000 over the decade. But this is achieved in years 1 and 2 ($26k back in 2 years) and it could well allow you to move into other investments.


This is an example of how an IRR can mask an underperforming asset. If any asset is bought with a view to using is as a stepping stone for more assets - and it doesnt allow you to do that - then regardless of the IRR that asset underperforms for you.


The spreadsheet is attached, fyi.


For further discussion on IRR, please refer to this thread and this one.


Mark

Mark, you explain IRR really well.

I am trying to fix an IP Calculator spreadsheet originally provided by Peter Noake. His IRR setup wasn't right, due to the Excel IRR function not accepting positive integers or 0 as the initial value in a cash flow series.

This got me thinking about whether IP equity used to fund 20% of a new IP, should be used in the IRR calcs. Some say only cash is included in IRR calcs.

I think it is safer to include the 20% equity, as it is part of the investment, and is an asset just like cash.

What do you think?

BTW, you mentioned you don't use IRR as a KPI. Would be interested to know what you do use. And if you have any advice on how to improve the accompanying spreadsheet.




Yumbi, re IRR masking things, my take on it, to add to Mark's very clear explanatin, is it is easy to fall into the trap of thinking an IRR is a steady x% return per annum for every year of the investment considered. Mark's examples show it isn't always, so can actually lead to unforeseen cash flow crises.

I think, and I'm working on recollection, that the IRR article was basically a way of saying that over time, an initially poor investment might recover, but that because the IRR was over a period of time but gave a single figure, far better profits which might be able to be made by timing the market would be lost. Timing the market, vs. time in the market.

The answer, obviously, is to take the IRR over a number of periods with differing start and finish dates and also as MArk says to use other indicators.

Because I'm a cashflow investor, I can't use IRR at all - all money is borrowed (zero investment) and each year has a positive cashflow, therefore IRR is infinite (and by defintion does not allow comparison between properties).

Which brings me to the final point. IRR is useful for comparing two essentially similar investments using the same assumptions, and in such a circumstance does NOT mask poor RELATIVE performance. the more dissimilar the investments, the more assumptions will need to be made, which will compromise the integrity of the comparison.

thefirstbruce said:

I am trying to fix an IP Calculator spreadsheet originally provided by Peter Noake. His IRR setup wasn't right, due to the Excel IRR function not accepting positive integers or 0 as the initial value in a cash flow series.

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TFB,

IRR only requires at least one negative and one positive cashflow (integer or not).
Then you can set the initial cashflow to zero.

cheers, Tony

tonyd said:

TFB,

IRR only requires at least one negative and one positive cashflow (integer or not).
Then you can set the initial cashflow to zero.

cheers, Tony

Click to expand...

Hi Tony, thanks for that. I didn't realize that is how it is designed.

However, if one wants IRR to work for positive geared investments, then it is necessary to have a negative entry initially, even if -$0.01 (not an integer)

But then it wouldn't work for fully negative geared investments combined with capital losses. But who would want to calculate IRR on an investment like that????

Hi again Tony. I tested your comments re IRR, and haven't been able to prove them correct. Could you check the accompanying SS.

TFB

Some good advice / information from quiggles and tonyd.

Re: what KPI's do I use?

Well, as I said I don't use the IRR function.

After suffering initially from analysis paralysis (ask people who have known me since I joined the forum), I have thereafter greatly simplified the due-diligence that I do.

I do believe that time, money and information (from wherever they come from) are my best friends (refer to thread), but I don't take it to the n'th degree (I am an economist, vis-a-vis I like to economise, and I do apply cost-benefit analysis to my due-diligence).

To answer your question - fwiw I use a cashflow spreadsheet and look for some indication that the property being considered won't burn too big a hole in my pocket*, relative to the CG that I percieve I can get out of it.

But why don't I use IRR?

Because CG is something I can only ever aim to achieve, but until you do achieve it, you never really know...

Or, as economists like to do, to quote myself:

Pitt St said:

Whether you call it an educated guess, smart buying, a gamble, whatever - when you buy an IP the CG is something you can only ever assume (that is, unless you have a pre-existing arrangement to sell at a higher price on a specific date).

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So, if I were to use an IRR then the results would be heavily dependant on my mood when I plugged in the figures. Optimistic = high CG and high IRR, pessimistic = lower CG and lower IRR, and so on.

I like to focus on what I know.

I'm happy to take an educated guess with the rest and obviously I will seek higher returns where I percieve they are available, but I don't let it make or break the deal.

Mark

* Obviously, I will (and have in the past) take + CF where I can get it, but thus far it has not been a core investment criteria for me.

Thanks Mark. I agree with what you say, and also Quiggles.
It's so easy to get caught up with analysing PI quandaries on a spreadsheet:
- pre-tax vs after-tax cash flows.
- should capital gains be indexed against inflation
- strength of correlation between inflation and interest rates.
- should non cash deductions be included in after-tax cash flows.
- stress testing with different interest rate and inflation scenarios.

At the end of the day, I agree with Steve McKnight's sharper focus on pre-tax cash flow, as risk minimization is really important to me....near money is dear money. Or as you point out, CGs are very much maybe money.

Further, I find getting outside one's own head and into the world, is often the path to greater investment opportunity, and too much analysis tends to lock one inside one's own head.

thefirstbruce said:

Hi again Tony. I tested your comments re IRR, and haven't been able to prove them correct. Could you check the accompanying SS.

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Hi TFB,

IRR can be a bit frustrating.
Sometimes there no solution.
Sometimes there is one solution.
Sometimes there are multiple solutions - the one you get depends on the initial guess you pass to Excel (defaults to 10%).

To really understand what is happening with the 3 cashflow series you give, one needs to plot the NPV for a range of interest rates. Since the IRR is defined as the rate where the NPV equals zero, you need to look to see whether the NPV curve actually crosses the x-axis. If it doesn't, then there is no solution.

I've played around a bit with Excel and plotted the NPV for each of the 3 series you give. Hopefully it is attached correctly.

Note that only the middle series (Series 2) crosses the x-axis (near 1.6). Hence the IRR can be read off in this case.

The other two series approach the x-axis asymptotically and may never cross at all. The IRR is essentially infinite.

This is what happens with no money down IP deals where you don't have a negative cashflow - the IRR is infinite because the NPV curve never crosses zero.

Hope that make sense!

cheers, Tony

ps. there is also an example highlighted in red where the first cashflow is zero.

Hi Tony, thanks a lot for your clear explanation. After doing a little more research on IRR in the last 24 hours, I am realizing it is a very limited indicator. I suppose anything that averages out random (or non random or in between) events will be.

If you have any suggestions on how two different asset class investments might be better compared, I'd appreciate your view. In business, NPV has always been my mainstay.

BTW, can I get your opinion on whether you think it is appropriate to use an initial LOC deposit on a new IP in a cash flow series.

thefirstbruce said:

Hi Tony, thanks a lot for your clear explanation. After doing a little more research on IRR in the last 24 hours, I am realizing it is a very limited indicator. I suppose anything that averages out random (or non random or in between) events will be.

If you have any suggestions on how two different asset class investments might be better compared, I'd appreciate your view. In business, NPV has always been my mainstay.

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AFAIK, NPV and IRR are the two most commonly used tools to compare investments. Another measure is the time it takes to recoup your initial outlay.

Note that IRR seems to work very well though for negatively geared investments where the cashflows are not normally "ill-conditioned".

I'm starting to read about the 'scenario analysis' that Pitt St alludes to: looking at expected returns with pessimistic, neutral, optimistic views of quanties like inflation, interest rates, capital growth, etc. This is often done with major development projects.
Whether it produces anything meaningful is another story. Just look the latest economic predictions from Company X!

thefirstbruce said:

BTW, can I get your opinion on whether you think it is appropriate to use an initial LOC deposit on a new IP in a cash flow series.

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I assume you mean that a LOC is used initially for a deposit and it is then topped up later when finance is sorted out...

Depends on the time resolution of your cashflows - annual, monthly, daily. If there is a big gap between these events (12 months+) then it would make sense to do so. If there was just a few months between these events then they really just cancel each other out.

cheers, Tony
(jumping on a plane soon, so can't read followups for a while)