Investing and the Internal Rate of Return

It is becoming difficult to watch television, browse the internet, or listen to the radio without being bombarded with pronouncements concerning the expected future price of gold, or some other “investment” for which the advertiser is hoping you will part with your money to purchase.  What many of these pronouncements left unsaid is when the anticipated event will occur.

It turns out that the when part of investment predictions is critically important.  The reason for this is because money’s time value nature.  It is widely known that a dollar tomorrow is less valuable than a dollar today.  Because of this, the timing of the returns that an investment generates can be just as important as the returns themselves.  When working with investments such as metals (gold and silver), growth stocks (that don’t pay dividends), and speculative real estate (with no cash flow) the time value of money takes on a characteristic of exceptional prominence since the investment returns are 100% dependent on an uncertain future value increase that requires the asset be sold for the gains to be realized.

As a way of demonstrating this phenomenon, we choose to model investments using the internal rate of return or IRR.  This metric measures the total time-adjusted rate of return for an investment, inclusive of the purchase price, cash flows, and eventual sale price.  The power of this metric is that it places greater emphasis on cash flows that occur early in the life of an investment, while discounting the value of future cash flows.  This is important, because a dollar today continues to be worth more than a dollar tomorrow, which is worth more than a dollar next week, and so on.

internal rate of return

In charting out the Internal Rate of Return for Income Property relative to Gold, there were some important simplifying assumptions that were made, which highlight the fragility of gold investing, and the robust nature of income property.  For the gold investments, we used the April 20, 2012 price of $1,642 as a starting point and assumed that the gold bug prediction of $2,500 per oz gold would come true.  However, we modeled different scenarios of when it would come true.  We also modeled in the 28% collectible gains rate for gold on all profits, but did not include transaction costs.

When modeling income property, we assumed a $79k property purchased for $21k of cash down, which produces $3,600 in annual cash flow that stay flat for all 15 years and a value that appreciates at 3% per year.  For the sake of simplicity, we assumed no depreciation benefit, no increase in rents, and no mortgage liquidation benefit.  The only things we counted were annual cash flows and appreciation above the purchase price.  We assumed a 25% federal and 9% state tax rate for the cash flows and a 1031 exchange for the sale after 15 years.  (In reality, your experienced IRR will be higher due to rent increases over time, mortgage liquidation and tax advantages from depreciation)

What our analysis of IRR showed us is that gold going to $2,500 is only beneficial if it happens fast.  Our conservative assumptions showed income property generating a 14% internal rate of return consistently over 15 years.  In order to accomplish this feat with gold, you would have to buy today, have it go to $2,500 within two years, and then sell to lock-in your profits before it goes down.  At this point, you would be left with the dilemma of what to invest in that will continue generating returns.

The fundamental problem with all “flash in the pan” investments is that they attract investors who see big short-term gains, but do not possess the necessary fundamentals for long-term success.  Income property investors understand that no single year should define your investing career.  It is much more important how you do over the course of a decade than in any single year.  By building a robust portfolio of high quality, income producing assets, it will place you in the position to realize many years of sustainably exceptional returns, instead of scrambling for whatever is “hot” at the current moment.

Action Item: Focus your investments in vehicles that will minimize the probability that your capital lays dormant for an extended period of time.  By focusing on investments that produce residual cash flows, it places the time value of money to work in our favor.