The financial management rate of return (FMMR) was introduced to the world of real estate investing because it addresses the length of investment term and risk of investment issue. Although FMMR is regarded a better mirror of real-world investment situations than the modified internal rate of return (MIRR) (also known as the avarage rate of return model) and internal rate of return (IRR), it has not been widely adopted as a common form of investment analysis by real estate investors because it is more difficult to calculate.
In fact, very few real estate investment software programs include FMMR because it is difficult to calculate, and opt instead to use MIRR because Excel provides a built-in MIRR calculation that the software developer can simply plug-in with the click of a mouse. Therefore if you want to use FMMR in your investment analysis, you can calculate it manually with some financial calculators, or get it calculated for you automatically inside real estate investment software (just be sure that the software provides it).
Okay, let’s see how FMMR compares to MIRR and why it is a serious investment return that real estate investors should know about and consider using.
Whereas modified internal rate of return (MIRR) makes the assumption that all annual cash outflows (investments) are discounted to a present value at an average rate and all positive cash inflows are reinvested at that same rate, financial management rate of return (FMMR) specifies cash outflows and cash inflows at two different rates known as safe rate and reinvestment rate. The FMMR also differs from the MIRR in that FMMR makes the additional assumption that positive cash flows occuring immediately after negative cash flows will be used to cover that negative cash flow, whereas the MIRR simply discounts back all negative cash flows to the beginning of the holding period at an average rate.
Here’s the idea. Safe rate assumes that funds required to cover negative cash flows are earning interest at a rate easily attainable and can be withdrawn when needed at a moment’s notice (i.e., like from a day of disposit account). Thus, the name “safe;” the funds are safely available when you need them. Reinvestment rate reflects that rate one might expect to receive if the positive cash flows were invested in a similar intermediate or long-term investment with a comparable risk. As you would expect, safe rate is a lower rate than reinvestment rate because it is highly liquid (i.e., requires minimal risk), and reinvestment rate is higher than safe rate because it is not liquid (i.e., it concerns another investment, and thus higher-risk).
Here’s how it works. All negative cash flows are discounted back over the course of the holding period at the safe rate until they are fully covered by the positive cash flows, and then all the positive cash flows are compounded foreward over the course of the holding period at the reinvestment rate. The result is the financial management rate of return; the rate of return an investor might expect to receive on real estate projects of that length of term and reinvestment risk.
What does it mean? Simply put, the FMMR provides the best way to compare alternative investments on a par (“apples-to-apples”) basis and is a better mirror of real-world situations.
ProAPOD real estate investment software provides the financial management rate of return in a proforma income statement that can be previewed here.
