What is Modified Internal Rate of Return?
IRR, or internal rate of return, is one of the most important financial metrics in commercial real estate investing. However, in many cases, a variation of IRR, called MIRR, or modified internal rate of return, can actually tell us more about the profitability of a commercial real estate investment, especially if we are considering that an investor may be reinvesting the cash from one CRE investment into other properties (or other types of investments).
IRR vs. MIRR: What’s the Difference?
IRR can be defined as the rate earned on each dollar invested for each period in which it is invested. MIRR takes this to another level by adjusting for the reinvestment of any positive interim cash flows by using a reinvestment rate. This is the rate at which an investor would be able to get if they reinvested the excess cash from their investment. In contrast, any negative cash flows are discounted back to the present by using a finance rate.
For instance (as represented by the table above), if a property was purchased for $110,000 and generated $10,000 a year of income over the next 3 years, after being sold for $120,000 at the end of the fourth year, and the reinvestment rate has been set at 10%, the IRR would be 12.94%, while the MIRR would be 12.69% (adjusting for the fact that the reinvestment rate is somewhat lower than the IRR). This corrects one of the main flaws of IRR, as it is often unrealistic to assume that an investor will be able to generate the exact same rate of return from any excess cash they reinvest.