The financial management rate of return (or FMRR) is a unique, but highly complex real estate investing rate of return that some argue is a better reflection of real-world investment situations than both internal rate of return (IRR) and modified internal rate of return (MIRR).
Nonetheless, despite its benefits, because of its complexity, it typically is not provided in real estate investment software, and otherwise requires a good conceptual understanding along with a financial hand-held calculator to compute – which requires a series of steps that are neither quick nor easy.
As a result, financial management rate of return is not commonly used by real estate investors – though it should be for several important reasons.
So in this article, we will look at FMRR in order to show you what it provides for real estate investors in hopes you will consider implementing it in your own real estate analysis.
Why a FMRR?
The model originated because some analysts felt that the one rate used in the IRR and MIRR models do not adequately account for the risk a real estate investor takes based upon the term of the investment.
They would suggest that more risk is incurred in intermediate and long-term investments and therefore higher rates of return would be expected for this higher risk position.
To deal with this, FMRR extends the reinvestment rate assumption to include two different rates.
The FMRR Model
Financial management rate of return addresses the length of investment term as well the risk issue associated with investment by specifying cash outflows and cash inflows at two different rates known as “safe rate” and “reinvestment rate”.
- 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assumes that funds required to cover negative cash flows are earning interest at a rate easily attainable and can be withdrawn when needed at a moment’s notice (i.e., like from a day of deposit account).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” because the funds are highly liquid and safely available with minimal risk 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. Reinvestment rate is higher than safe rate because it is not liquid (i.e., it concerns another investment) and thus higher-risk.
FMRR also makes an additional assumption not included with IRR and MIRR. That positive cash flows occurring immediately prior to negative cash flows will be used to cover that negative cash flow.
Determine a safe rate and reinvestment rate (higher than the safe rate) to apply to all future cash flows over the course of a specific holding period.
- Remove all future negative cash flows by utilizing the prior year’s positive cash flows where possible. In this case, negative cash outflows are discounted back at the safe rate and subtracted from any positive cash inflows.
- Discount all remaining negative cash flows (if existing) to the present at the safe rate.
- Compound forward (to the end of the holding period) those positive cash flows remaining at the reinvestment rate. These are added to the cash flow (i.e., reversion) anticipated from a sale at termination of the investment at the end of the holding period.
- Calculate the IRR.
The result is the financial management rate of return.
So You Know
ProAPOD real estate investment software includes the financial management rate of return calculation in two of its solutions. Executive 10 real estate investing software and iCalculator online real estate calculator.