SB Equities

This month’s Financial Strategies column in Properties Magazine continues a discussion that begin in the March issue.  The topic for both months was Internal Rate of Return.  In March, we gave some framing to the concept of IRR, explaining what it is and how it is used.  And in the April issue, we tackle some of the shortcomings associated with IRR.  You can read the entire article by clicking here.

The remainder of this blog entry will focus on the Capital Accumulation process.  This process helps to overcome the primary pitfalls to using IRR.  The easiest way to explain how Capital Accumulation works is by using an example, so here goes.  Suppose that an investor is evaluating two alternative investment properties.  He reduces each of the properties respective financial profiles into a T-bar for each, which looks like this:

For those that are unfamiliar with a T-bar, it simply is a financial profile of an investment over a time horizon.  So in our example, there is an initial investment to purchase each property, there are various positive and negative cash flows each year and each of the properties are then sold at the end of their hold period.  If the investor were to use IRR to compare each of these investments, it would be a flawed comparison for several reasons.  First, Property A has a negative cash flow that occurs in the third year and negative numbers will cause the actual IRR calculation to be flawed.  Second, the initial investment required for Property A is greater than for Property B but IRR gives no consideration to the treatment of this disparity.  The investor’s initial war chest has to be at leaset $1,250,000 or he would not be considering Property A.  But if he elects to purchase Property B, he will still have $250,000 in his war chest.  Although he could just stick this extra cash in his mattress, it is more likely that he would invest this in a secondary investment.  Third, Property B is held for 2 years longer than Property A but IRR gives no consideration to the treatment of this disparity.  We know that the investor is willing to keep his money invested for at least 7 years or he would not be considering Property B.  But if he purchases and then subsequently sells Property A after only 5 years, he will have cash proceeds that could be re-invested for the additional 2 years.  And fourth, there is no consideration given for any of the cash proceeds that are produced throughout the holding period of each investment.  Although the investor could just stick this cash in the mattress, it is much more likely that he would re-invest these into a secondary investment.

So how does this all work?  Below is a mapping of sorts for the Capital Accumulation process for Property A.

The goal of Capital Accumulation is to equalize a comparison of these investments by addressing the four shortcomings.  It does so by making two assumptions – one for what happens to positive cash flows (called the reinvestment rate) and one for what happens to negative cash flows (called the safe rate).   Lets tackle the positive cash flows first.  It is assumed that any positive cash flows can be reinvested at a given reinvestment rate.  Maybe its a CD or a money market account or a T-bill or a dividend-paying stock but a blanket assumption is made that any positive cash flows produced by an investment can then be re-deployed in a secondary investment that will produce this given reinvestment rate.   The negative cash flows are a little different.  These must be eliminated from the analysis.  The way this is done is by discounting the negative cash flow from the year that it occurs back to the closest year with a positive cash flow.  The discount rate that is used for this is called a safe rate and represents a rate that the investor is guaranteed to achieve.

The best way to illustrate the Capital Accumulation process is to actually map out the procedure for each Property.  For each, we will use a re-investment rate of 6% and a safe rate of 2%.  Here is how Property A would map out.  The first step is to eliminate the negative cash flow that occurs in Year 3.  We do this by discounting the ($25,000) back one year at our safe rate, which is 3%, which results in a discounted cash flow of ($24,510), which is now in year 2 (remember, we discounted it back one year).  This is then netted against the cash flow that is already in year 2, $105,000, and results in a revised year 2 cash flow of $80,490.  This is how the first step would map out:

A quick note about negative cash flows - they need to continue to be discounted back until they are eliminated.  If the postive cash flow in year 2 would have been $20,000 instead of $105,000, the net result would have still been a negative cash flow (in this instance, a negative $4,510).   So this would need to be discounted back another year at the safe rate and netted against year 1. 

The second step is to re-invest the postive cash flows forward to the end of the hold period at the stated reinvestment rate.  This is fairly straight-forward, with the cash flow from year 1 compounded forward 4 years at 6%, the revised cash flow from year 2 compounded forward 3 years at 6%, etc.  Mapping this out, the T-bar would look like this:

The third step is to equalize the initial investments.  If the investor chooses to buy Property A rather than Property B, he will still have $250,000 left over.  We treat this the same way that we treated the positive cash flows in the second step – by compounding it forward at the reinvestment rate of 6% until the end of the hold period.  So the $250,000 would be compounded over the entire hold period of 5  years.  And after step three, the T-bar for Property A would look like this:

The fourth and final step is to equalize hold periods.  Property A is held for 5 years and Property B is held for 7 years.  To account for this additional two years, we need to move all of the cash flows that are now sitting in year 5 forward an additional 2 years.   We do this using the same procedure that we used in steps two and three – by compounding the summation forward two years at the reinvestment rate of 6%.  After step four, the T-bar for Property A would look like this:

All of our adjustments are now complete for Property A – we eliminated the negative cash flow, we reinvested the periodic cash flows during the hold period, we equalized the initial investment amounts and we equalized the hold periods.  And the fully adjusted T-bar looks like this:

We can now turn our attention to Property B and run through the same four steps.  The first step is to eliminate any negative cash flows.  Seeing none, we can move on to step two.  We use the same reinvestment rate of 6% in this step.  Mapping out this step for Property B would look like this:

The third step is to equalize initial investment amounts but, since Property B was the more expensive of the two, no adjustment is needed.  And the fourth step is to equalize the holding periods but again, since Property B was held longer, no adjustment is needed.  So the final, fully-adjusted T-bar for Property B looks like this:

So, as my friend and fellow CCIM instructor Tim Hatlestad likes to say – who cares?  Well, if I am an investor that is trying to decide to buy Property A or Property B, I do.  The Capital Accumulation process tells me which property will ultimately put more money into my pocket at the end of 7 years.  It does this by eliminating one of the flies in IRR’s ointment – negative cash flows.  It does this by accounting for cash flows not only while they are inside of the investment but also once they come outside of the investment.  And it does this by equalizing differences in both initial investments and holding periods.  So when all the dust settles, I can clearly see that Property A will put $2,102,290 in my pocket while Property B will put $2,066,176 in my pocket.  And while it may not be the be-all/end-all, the Capital Accumulation process certainly is another valuable tool in the savvy investor’s toolkit.