Internal Rate of Return - Posted by John Behle
Posted by John Behle on November 15, 1998 at 15:21:14:
Your return on investment can be as simple as entering a few numbers into a financial calculator.
The formulas built into the calculator take into account the cash you have paid out, cash you receive back and the time periods.
If I invest $10,000 and get back $15,000 in three months, I would enter negative $10,000 into the PV register of the calculator. PV is for PRESENT VALUE. I would enter 3 into the N register in the calculator. N is for the time period or NUMBER OF PAYMENTS. I enter $15,000 into the FV register of the calculator. FV is for FUTURE VALUE - an amount received at a future date. Since there are no monthly payments in this case, we enter a 0 into the PMT register. PMT stands for PAYMENT.
We then solve for the %I register. In most calculators, this is just a matter of pushing the key. In some of the calculators you need to push the CPT key (compute) or the “2ND” key (also compute) and then the “%I” key. This will give you the rate of return. Some calculators will return this as an annual rate and some will return a periodic rate that must be multiplied by 12 to equal an annual rate. In this example, your yield should come back as 173.66% if the calculator is calculating based on 3 months. You can also calculate based on an annual basis, which would mean 1/4 of a year and an annual return of 200%.
This is just one basic example. The subject of rates of return and using the calculator is at least a one day course to really understand it. The CCIM CI101 course takes one full week to cover it but includes taxation and a more accurate rate of return that is called the “FMRR” or Financial Management Rate of Return.
Unfortunately most calculators do not have very easy to understand manuals when it comes to the IRR (Internal Rate of Return) calculations. There are a couple books on the subject of time value of money calculations. “Calculator Power” by Jon Richards or “Discounting as Easy as 1,2,3” by myself.
The basics are actually quite simple. Once you understand them, then the whole subject becomes clear in sort of an “A HA!” type manner for most people.
There are three types of cash flows that you discount and a simple three step process that works on any financial calculator.
Learning the time value of money and how to use a financial calculator is one of the most valuable things you can learn as a real estate investor and absolutely mandatory for a “paper” investor. There are more details on the time value of money in the “How to articles” section and in the Cash Flow Forum on this site.