What Is Financial Management Rate of Return – FMRR?
The financial management rate of return (FMRR) is a metric used to evaluate the performance of a real estate investment and pertains to a real estate investment trust (REIT). REITs are shares offered to the public by a real estate company or trust that holds a portfolio of income-producing properties and/or mortgages.
The FMRR is similar to the internal rate of return and takes into account the length and risk of the investment. The FMRR specifies cash flows (inflows and outflows) at two distinct rates known as the safe rate and the reinvestment rate.
The Financial Management Rate of Return Explained
Because the calculation of financial management rate of return is so complex, many real estate professionals and investors choose to use other metrics for real estate analysis. The benefit of using FMRR is that it allows investors to compare investment opportunities on par with one another.
Although the Internal Rate of Return (IRR) has long been a standard measure of return within the financial lexicon, a primary drawback is the value's inability to account for time or a holding period. As such, it's a weak indicator of liquidity, which plays a material role in determining the overall risk level of any given investment security or vehicle. For instance, when using just IRR, two funds may look alike based on their rates of return but one may take twice as long as the other to simply getting back to an original principal investment amount. Many analysts will supplement IRR or MIRR return measures with the payback period to assess the length of time required to recoup a principal investment sum.
The modified internal rate of return improves on the standard internal rate of return value by adjusting for differences in the assumed reinvestment rates of initial cash outlays and subsequent cash inflows. FMRR takes things a step further by specifying cash outflows and cash inflows at two different rates known as the “safe rate” and the “reinvestment rate.” 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.
- Safe rates assume that funds required to cover negative cash flows are earning interest at a rate easily attainable and can be withdrawn when needed at a moment’s notice (i.e., like from a day of deposit account). In this instance, a rate is “safe” because the funds are highly liquid and safely available with minimal risk when needed.
- Reinvestment rates include a rate to be received when positive cash flows are reinvested in a similar intermediate or long-term investment with comparable risk. The reinvestment rate is higher than the safe rate because it is not liquid (i.e., it pertains to another investment) and thus requires a higher-risk discount rate.
- The financial management rate of return (FMRR) is a metric used to evaluate the performance of a real estate investment and pertains to REITs.
- The FMRR relies on a modified IRR formulation that employs a safe rate of return and a reinvestment rate of return.
- Because the calculation of financial management rate of return is so complex, many real estate professionals and investors choose to use other metrics for real estate analysis.
Since FMRR is a modified internal rate of return, there is no formulaic way to calculate it, rather it must be computed by iterations of trial and error, made easy by computer software. Before using such software, there are some important steps that must be undertaken to 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.
- Take out all of the future negative cash flows by looking at the previous year’s positive cash flows whenever possible. Outflows are instead discounted back at the safe rate of return and subtracted from any positive cash flows.
- Discount all other cash outflows that may not have applied to step 1 to the present at the safe rate as well.
- Compound forward to the end of the holding period the remaining positive cash flows at the reinvestment rate. These will then be added to the projected cash flows anticipated from a sale at the end of the holding period of the investment.
- Calculate the IRR.
The result is the financial management rate of return.