How can an investor compare the projected returns on alternative commercial real estate investments?

By: Colliers | Houston
HOUSTON - Aug. 31, 2023 - PRLog -- As with many aspects of the commercial real estate business, there is more than one way to answer this question. Aside from the non-financial decision influencers, such as the property type, location, and perceived risk of various commercial real estate investments, there are two approaches an investor can use to evaluate alternative investments. Once you have projected the cash flows for two alternative investments, you can calculate the internal rate of return (IRR) for each, assuming an initial investment. The IRR is a metric used in capital budgeting to measure the profitability of potential investments. It is commonly used in LBOs, capital projects, and real estate. IRR measures the total return on a sponsor's equity, including any additional equity contributions made, or dividends received, during the investment horizon. IRR is defined as the discount rate that must be applied to the sponsor's cash outflows and inflows during the investment horizon in order to produce a net present value (NPV) of zero.

The IRR is a common metric for an investor to consider. Yet, what is missing? An IRR does not reflect the potential reinvestment of the cash flow proceeds, or cost of generating funds for any cash flow shortfalls, over the hold period. An IRR calculation assumes the money is reinvested at the same rate. There are two approaches which will take this factor into consideration: one is capital accumulation and the other is the modified internal rate of return (MIRR).

Capital accumulation is the total monetary value accumulated over a hold period (duration of ownership), while the MIRR is a rate of return, assuming positive cash flows are reinvested and capital outlays are financed. To illustrate these methodologies, we'll consider the following two investments which provide the same IRR to the investor.

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Source:Colliers | Houston
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