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What Is Financial Management Rate of Return (FMRR)?
The financial management rate of return (or FMRR) is a beneficial (but lesser known) real estate investment performance measure taught by the Commercial Investment Real Estate Institute (or CCIM).
The idea for the financial management rate of return stems from the fact that the internal rate of return (a widely accepted and more popular investment performance measure) assumes periodic annual cash flows during the holding period are reinvested at the same rate (i.e., the IRR) which CCIM suggests doesn't make financial sense.
The financial management rate of return overcomes this shortcoming by making three assumptions.
- Positive cash flows occurring before negative cash outflows will be used to cover negative cash outflows
- Funds will be invested at a “safe rate” to service periodic negative cash flows
- Funds collected in excess of financial obligations will be invested at a “reinvestment rate” into average investments of intermediate duration
Financial management rate of return is based upon the notion which includes the following components common to real estate investing objectives and practice.
Wealth maximization – real estate investors primarily seek to maximize their long-term wealth position, therefore the wealth investors can hope to accumulate by owning the real estate investment is vital.
Cash flows after tax – only cash flows after taxes are evaluated because real estate investors want to gauge the desirability of an investment based upon the amount they might collect after satisfying the IRS.
Safe rate – a rate the investor can safely collect on funds invested in a highly liquid account (i.e., a checking or savings account) and withdrawn when needed without penalty to cover future financial obligations associated with the real estate investment property.
Reinvestment rate – a rate the investor might expect to receive from some minimum amount of future funds not required to meet financial obligations of the property that are reasonably reinvested in average investments of intermediate duration and comparable risk.
Similar risk – real estate investors want the opportunity to compare various investments that are somewhat comparable in duration and similar in risk.
Funds set aside to cover any future financial obligations from the property can be invested at any time in any amount at a rate that provides safety and near instantaneous liquidity. Funds in excess of these contingency funds can be reinvested in other "run of the mill" investments of similar risk at a rate higher than the safe rate. Positive cash flows occurring prior to negative cash outflows are used to cover negative cash outflows.
FMRR (not unlike IRR) measures the future financial performance of investment real estate by equating the initial cash investment (year 0) along with all future annual cash flows estimated for the holding period (including sale proceeds) on an end-of-year basis.
CF0 cash investment
CF1 cash flow
CF2 cash flow
CF3 cash flow
CF4 cash flow
CF5 cash flow+ cash proceeds (future sale)
In this case, the IRR would be the internal rate of return which results in the investment value being exactly equal to the discounted future benefits (i.e., cash flows and sales proceeds). In other words, IRR is the discount rate at which future cash flows are discounted back to year 0 to equal the initial cash investment and thus provide the yield.
The FMRR differs in that it specifies two different rates to make the calculation. A "safe rate" for discounting and a "reinvestment rate" for compounding.
Here’s how it works.
Positive cash flows are discounted back at the safe rate until all negative cash flows are removed (where possible). Negative cash flows that remain are then discounted back at the safe rate back to year 0. Then all the positive cash flows (where possible) are compounded forward at the reinvestment rate to the end of the holding period.
Okay, now let’s consider what the schema we illustrated above looks like after the FMRR adjustments. The result would be an amount for year 0 (investment) and for year 5 (referred to as the Accumulation of Wealth) along with zero amounts for all years in between.
CF5 Accumulation of Wealth
Afterward, the internal rate of return computation is applied and the result is the financial management rate of return (FMRR).
The financial management rate of return model provides real estate investors with a better indication of the true capital requirements of the project as well as a long-term wealth position. So it really is a better real estate investment measure that should be included as part of any real estate analysis.
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