One of the basic tenets of investing is that it pays to reinvest cash flow to increase the amount of capital that you are earning a return on. In fact, over the course of a career, reinvesting cash flows or proceeds from distributions can make an enormous difference in an individual investor’s total return, net worth and standard of living. In this article we are going to explore what a reinvestment rate is, how to calculate it, and how to apply these ideas to commercial real estate to help investors achieve their investment objectives.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. We understand the importance of reinvesting capital over the long-term and work diligently to create reinvestment opportunities for our investors . If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
What is a Reinvestment Rate?
A reinvestment rate is defined as the portion of an investor’s profit or cash flow that they reinvest back into a company or deal to continue earning a return on that new capital. In fact, reinvesting capital over the long-term is a key factor in any winning investment strategy across different asset classes. Let’s discuss a few examples to make it clear how reinvestment rates can be applied to different asset classes to improve investment returns.
In commercial real estate, where we specialize, investor cash flow typically comes in the form of distributions from the proceeds of rental income generated from investment properties. These properties can be owned directly by the investor, or, if the investor is accredited, they can invest in a commercial real estate private equity firm like ours. Either way, the investor will receive cash flow assuming the properties in the portfolio perform well. The cash flow received from the rental income can be reinvested. The investor has the option to purchase additional property on their own or invest more capital into deals that a private equity firm offers.
Reinvesting is also a common strategy in stock market, mutual fund, exchange-traded funds (ETFs), and fixed income investing. With stock, mutual fund, and ETF investments, investors receive dividends and capital gains distributions, which can be used to purchase additional shares. These are typically deposited with the investor’s brokerage and can be transferred to an FDIC-insured account or reinvested into additional shares as part of an investment management strategy. It’s important to note that funds reinvested into additional shares of stock will be bought at the prevailing market price.
Fixed income investments are another way that real estate investors can receive cash flow to reinvest. The exact timing and structure of the interest payments depends on the type of fixed income securities the investor owns, whether corporate bonds, municipal bonds, etc. Regardless, investors receive coupon payments, also known as interest payments until the maturity date. It’s worth noting that fixed income proceeds depend on the interest rates attached to the instrument, but regardless, they can be reinvested as the investor sees fit. The terms of any fixed income instrument can be found in the prospectus made available by the issuer.
Calculating Reinvestment Rates
Now that we know what a reinvestment rate is and how different asset allocation strategies can result in different reinvestment options, let’s turn our attention to how reinvestment rates are calculated.
When thinking about a private equity firm or corporation, there are three terms that investors need to know to calculate the reinvestment rate. We’ll go into detail on these terms below, but they are Net Capital Expenditures (Net CapEx), Changes in Net Working Capital (NWC), and Net Operating Profit After-Tax (NOPAT). The equation used to calculate the reinvestment rate is as follows:
Reinvestment Rate = (Net CapEx + Change in NWC) / NOPAT
Let’s define these terms.
What is Net CapEx?
Net CapEx is defined as the amount allocated to capital expenditures less the asset depreciation that the CapEx is meant to address. Capital expenditures are the costs associated with replacing or improving an asset. In the case of commercial real estate, it’s easy to confuse CapEx with net operating costs, but they aren’t the same thing. CapEx relates to investments in long-term assets that are used to generate revenue and help the company or investment operation grow. Operating expenses are short-term costs associated with repairs and maintenance of a property.
Changes in Net Working Capital
Net working capital refers to the difference between the amount of current assets and current liabilities that a company or investment firm has on hand. Current assets include things like cash, accounts receivable, inventory, and any other asset that is expected to be used or sold within one year’s time. Current liabilities are accounts payable or debts due within the next twelve months. Net working capital is calculated by subtracting current liabilities from current assets.
Changes in net working capital refers to fluctuations in the difference between current assets and liabilities over time. It is calculated by subtracting the net working capital for the prior period from the net working capital for the current period.
Change in Net Working Capital = Prior Period NWC – Current Period NWC
What is NOPAT?
NOPAT stands for Net Operating Profit after Taxes. It is a metric that is meant to help investors understand how a company or investment operation has performed after paying taxes on operating profits. The formula used to calculate NOPAT is as follows:
NOPAT = Operating Income × (1−Tax Rate)
Let’s explore these terms one-by-one to make things clearer.
Operating Income is gross profit less operating expenses. For commercial real estate investors, this usually means rental income less expenses associated with maintenance, property management, insurance, and property taxes (not income taxes).
The Tax Rate is the percentage of operating income that the government mandates that the company or investment firm must pay. By calculating (1 – Tax Rate), we are able to determine how much of the operating income the company or investment firm gets to retain.
An Example of the Reinvestment Rate Calculation
Now that we understand the formula and terms involved in calculating the reinvestment rate, let’s work through an example for a hypothetical real estate fund. The tables below show the full results for Year 1 and Year 2. These tables form the basis for the calculations that follow.
Year 1 | Year 2 | |
Capital Expenditures (CapEx) | $1,000,000 | $1,500,000 |
(-) Depreciation | $400,000 | $600,000 |
Net CapEx | $600,000 | $900,000 |
Year 1 | Year 2 | |
Current Assets | 1,600,000 | 1,800,000 |
Current liabilities | 1,100,000 | 1,200,000 |
Net Working Capital (NWC) | $500,000 | $600,000 |
Change in (NWC) | N/A | $100,000 |
Year 1 | Year 2 | |
EBIT | $10,000,000 | 12,000,000 |
Tax rate | 20% | 20% |
NOPAT [EBIT / (1 – tax rate)] | 8,000,000 | 9,600,000 |
We’ll start by working through the Year 1 results.
Capital expenditures taken in aggregate, amount to $1M, and depreciation amounts to $400,000. Taking the difference of these two terms yields the Net CapEx amount of $600,000.
Additionally, at the end of year 1, we know that the net working capital is $500,000, which is defined as the current assets of $1.6M less the current liabilities of $1.1M. There is no change in the net working capital in year one because it is the beginning of the period under consideration.
Earnings before interest and tax (EBIT) in Year 1 is $10M, which the firm must pay a 20% tax on. The NOPAT left after paying the $8M tax.
Now we’ll look at the Year 2 results
Capital expenditures taken in aggregate, amount to $1.5M, and depreciation amounts to $600,000. Taking the difference of these two terms yields the Net CapEx amount of $900,000.
Additionally, at the end of Year 2, we know that the net working capital is $600,000, which is defined as the current assets of $1.8M less the current liabilities of $1.2M. The change in the net working capital compared to Year 2 is $100,000 ($600,000 – $500,000).
Earnings before interest and tax (EBIT) in Year 2 is $12M, which the firm must pay a 20% tax on. The NOPAT left after paying the $9.6M tax.
Now that we have the Year 2 terms, we can calculate the reinvestment rate.
Reinvestment rate = (900,000 + 100,000) / 9,600,000 = 10.4%
The reinvestment rate for the firm is 10.4%, which means the firm reinvests just over 10% of the post-tax operating income (NOPAT) to support capital expenditures or working capital.
How Are Reinvestment Rates Used In Commercial Real Estate?
Now that we know how to calculate the reinvestment rate for a company or investment firm, let’s discuss how this rate is used by commercial real estate investors when doing due diligence on a deal. When investors make investment decisions there are many factors that come into play, including volatility, risk tolerance, market conditions, diversification, and the ability to reinvest proceeds at satisfactory rates of return. Of course, investing at higher rates is even more desirable.
When building a pro forma and doing financial modeling as part of the due diligence process, many investors will use the reinvestment rate to help them determine an overall rate of return on the project. Let’s look at two related return metrics that investors often use in conjunction with the reinvestment rate.
Reinvestment Rates and Modified Internal Rate of Return (MIRR)
One of the most common and insightful rate of return metrics in commercial real estate is called the Modified Internal Rate of Return (MIRR). This is a return metric that helps investors to rank projects, deals, or potential investments. It is similar to Internal Rate of Return (IRR), but it has a couple of key differences that we will discuss in the next section. Perhaps the most important feature of the MIRR calculation is that it allows investors to use a reinvestment rate that is different from the discount rate used to model the cash flow generation. In other words, it allows investors to assume that cash flows generated in the future will be reinvested at a different rate than the discount rate prevailing at present. This is a powerful feature because it allows investors to be more precise in how they build the valuation model for the deal.
Internal Rate of Return (IRR) vs. Modified Internal Rate of Return (MIRR)
We just discussed the basic idea behind the MIRR. Now let’s see how MIRR compares to IRR. First, it’s important to know that IRR is the discount rate that sets the net present value (NPV) of all future cash flows equal to zero, and it is often used as a proxy for the annual rate of return or interest rate that is earned on a projected series of cash flows. In other words, the IRR framework automatically assumes that future cash flows will be reinvested at the discount rate prevailing at present. Of course, this might not be the most accurate way to value the investment. If the IRR ends up being higher than the rates that investors can reinvest at later, then the projected annual returns of the project will be overstated. This results in potential investment risk because the investor might be inclined to invest in a deal that looks better on paper than it proves to be over time.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in. If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.