Why Financial Management Rate of Return is used by Investment Analysts

Financial management rate of return (or FMMR) is a return that was conceived (I do believe) by the Commercial Investment Real Estate Institute (CIREI) and is taught to students seeking the CCIM (Certified Commercial Investment Member) designation. So I'll give the CIREI the credit for the financial management rate of return with the reservation that I might be mistaken and it originated elsewhere. Fair enough.

Okay, so what exactly is a financial management rate of return, what does it signify exactly, and how do you compute it?

The idea behind the return is that investors often are confronted with selecting among alternate investments which internal rate of return (IRR) doesn't adequately provide and therefore this return was introduced so investors can make par basis ("apples-to-apples") comparisons between investments.

According to CIREI the basic components of FMMR are based upon the notion that real estate investors seek to maximize their long-term wealth, and as a result must account for positive after-tax cash flows.

In other words, if an investor is collecting $1,000 a month from a particular rental property (after financing and taxes) it can be assumed that those funds would not be buried under a mattress. That the investor would instead option to deposit a portion in the bank and collect what the institute calls a "safe rate", and then reinvest certain minimum amounts in excess of those funds in some other "run of the mill" investment to collect after-tax yields at what is called a "reinvestment rate".

In this case, CIREI explains that the funds placed in a "safe rate" account are assumed to be highly liquid and can be withdrawn on a moments notice without loss of either principal or interest. Whereas the funds yielding the "reinvestment rate" are those that would not be needed to meet other cash requirements of the property (therefore not highly liquid).

The computation for FMMR is highly complex. In fact, other than my own real estate investment software, I've never seen any other software solution tackle it. Here's how it works in concept.

After-tax cash flows for any particular investment are projected out over some number of years on an annual end of year (EOY) basis. First, any negative cash flows are discounted back to the initial investment at the "safe rate" (unless removed by prior positive cash flows), and then afterward any remaining positive cash flows are compounded forward to the specified year of sale at the "reinvestment rate".

For example, say we want to compute the financial management rate of return for a property we expect to hold for five years. Our initial investment is considered EOY 0 and each annual cash flow considered EOY 1 through EOY 5 accordingly; our projected sale proceeds are included at EOY 5.

First, we must "discount" all negative cash flows at the "safe rate" until they are zeroed out by positive cash flows in the previous years or until no other positive cash flows remain in any previous year. For example, if EOY 1 and EOY 2 are both negative, then both are discounted back to EOY 0 and added to the initial investment (also considered a negative amount).

Next, we must "compound" any remaining positive cash flows to the year of sale at the "reinvestment rate". For example, if EOY 4 is positive, then we would compound it to EOY 5 and subsequently add it to the cash flow for that year (assuming that it is positive) as well as to the proceeds we expect to receive when we sell the property in that year (also considered positive). CIREI calls this total sum the "accumulation of wealth".

Okay, so here's how we end up. There will be a negative dollar amount in EOY 0 and a positive dollar amount in EOY 5 (all the years in between become zero).

Here's the schema:

EOY0 (negative) initial investment + (negative) cash flows = (negative) total dollars
EOY1 0
EOY2 0
EOY3 0
EOY4 0
EOY5 (positive) sale proceeds + (positive) cash flows = (positive) total dollars

Finally, you would compute the internal rate of return (IRR) based upon that schema to arrive at the financial rate of return.

Due to the complexity of the computation you probably want to use a financial calculator or our calculator software (which is easier) or our real estate investment software (which computes FMMR automatically as you provide the data for the rental property you might be analyzing). Whatever you choose, here's to your success.

Article Source: http://www.moneyarticlelibrary.com

James Kobzeff is the developer of ProAPOD - leading real estate investing software since 2000. Create rental property cash flow, rates of return, profitability analysis presentations in minutes (including financial management rate of return)! Learn more => www.proapod.com

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