The need to annualize monthly returns does not arise often in commercial property investment analysis as it is structured in most cases on a quarterly or annual basis.
However, there are occasions that the analyst may use monthly cash flows in a discounted cash flow (DCF) model in order to estimate the expected internal rate of return (IRR) for a particular property investment. In such a case the estimated monthly internal rate of return can be converted to annual using the following formula:
IRRAnnual = ( 1 + IRRMonthly)12 – 1
To demonstrate the use of the above formula in order to annualize monthly returns, consider that we have a monthly cash flow analysis for an apartment, and that by using the Excel @IRR formula we derive an IRR estimate of 0.8%. Since, this IRR is estimated using monthly cash flows it reflects the average monthly return expected to be achieved by the property over the period of analysis. We can convert this monthly return into annual by applying the above formula as follows:
IRRAnnual = ( 1 + 0.008)12 – 1 = 1.10034 – 1 = 0.103 = 10.3%
Therefore, the particular property investment is expected to achieve an annual return of 10.3%. Notice though that the IRR is a holding-period return and provides the average monthly return (since the cash flows are monthly) assuming that positive cash flows are reinvested from the time they are received until the end of the holding period, earning a rate of return equal to the estimated IRR. However, we may have return estimates separately for each month, which may be different as monthly cash flows fluctuate. In such a case the formula we can use to annualize monthly returns is:
RAnnual = [ ( 1 + RJanuary) x ( 1 + RFebruary) x ……( 1 + RDecember)] – 1
RJanuary = estimated monthly return for January
RFebruary = estimated monthly return for February
Of course, if the 12-month period for which we want to annualize monthly returns does not represent a calendar year, the formula is the same, but the sequence of months will be different. In any case, in this formula, it does not matter which return is obtained earlier or later within the year. The annual return calculated with this formula will be still the same even if we change the timing by which these monthly returns are received.