Financial management rate of return (or FMRR) is a return conceived (at least I think it was) by the Commercial Investment Real Estate Institute (CIREI) and is taught to those who seek the CCIM (Certified Commercial Investment Member) designation.
Having taken several courses at CIREI, I do know at least that they promote the FMRR return and teach how to calculate it. And given that I have never heard the term used elsewhere, I’ll simply give them the credit for the financial management rate of return with the reservation that I might be mistaken and that it might actually have originated elsewhere.
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 IRR (internal rate of return) doesn’t adequately provide, therefore it became necessary to introduce this return so investors can make par basis comparisons between investments (i.e., apples-to-apples).
The basic components of FMRR (according to CIREI) 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 one thousand dollars a month from a particular rental property after financing and taxes are evaluated 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 in turn reinvest certain minimum amounts in excess of those funds in some other “run of the mill” investment and collect after-tax yields in what they term as a “reinvestment rate”.
As a disclaimer, CIREI adds that the funds placed in a “safe rate” account are assumed to be highly liquid and can be withdrawn on a moments notice without loss of either principal or interest, and the funds yielding the “reinvestment rate” are those that would not be needed to meet other cash requirements of the property.
The computation for FMRR 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 EOY (end of year) basis. Any negative cash flows get discounted back at the safe rate until they are removed by prior positive cash flows (where possible) and positive cash flows (if any exist) are compounded forward at the reinvestment rate.
Let’s assume that we want to compute the financial management rate of return based upon the cash flows we expect starting EOY 0 (our initial investment) through EOY 6 (when we expect to sell the property).
If at the EOY 2 a positive cash flow of $50,000 is expected and a negative cash flow of $60,000 at the EOY 3, the negative would be discounted back at the safe rate to the EOY 2 and reduced by the positive. If a negative amount still remains (in this case it does) then it is discounted back to the EOY 1 and again reduced by a positive cash flow (if it exists). But we’ll say that the expected cash flow at the EOY 1 is also negative. Therefore, because EOY 1 and EOY 2 are both negative, they are each discounted back at the safe rate to EOY 0 and added to the initial investment (also considered a negative amount).
Likewise, if we assume that all other cash flows are positive then those amounts are each compounded forward at the “reinvestment rate” and added to the funds we expect to receive at the EOY 6 (i.e., that year’s cash flow plus sale proceeds), the sum total of which CIREI calls the “accumulation of wealth”.
Okay, now that we determined the amount for EOY 0 and EOY 6 and zeroed out all years in between we compute for IRR to arrive at the financial management rate of return (FMRR).