The financial management rate of return (FMRR) was introduced to the world of real estate investing by the Commercial Real Estate Investment Institute because it addresses the length of investment term and risk of investment issue. At least that’s where I first learned about it.
Although FMRR is regarded a better mirror of real-world investment situations than both the modified internal rate of return (MIRR) (also known as the average 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 FMRR 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 FMRR in your investment analysis, you can calculate it manually with some financial calculators or get it calculated for you automatically inside ProAPOD Real Estate Investment Software.
Okay, let’s see how FMRR 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 (FMRR) specifies cash outflows and cash inflows at two different rates known as “safe rate” and “reinvestment rate”.
The FMRR also differs from the MIRR in that FMRR makes the additional assumption that positive cash flows occurring 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assumes that funds required to cover negative cash flows are earning interest at a rate easily attainable and can be withdrawn when needed at a moment’s notice (i.e., like from a day of deposit account).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 forward 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 FMRR provides the best way to compare alternative investments on what the institute calls a par (“apples-to-apples”) basis. Therefore it is a better mirror of real-world situations.
So You Know
ProAPOD real estate investment software provides the financial management rate of return in the proforma income statement created in its Executive 10 real estate investing software solution and can be previewed at http://www.proapod.com/real-estate-investing-software-reports.htm. Simply scroll down to Proforma Income Statement and click [Preview].
