Understanding Net Present Value | Know Whether The Next Income Property You Buy Will Achieve Your Desired Yield!

The return known as net present value (or NPV) is commonly used a real estate analysis by real estate investors because net present value reveals to the investor whether the rate of return he or she desires will be achieved, and thus, whether or not the property is profitable enough for the investor to consider making the capital investment.

Specifically, net present value measures the present value of a property’s future benefits discounted by the investor’s target rate of return against the capital required to make the purchase.

This way, the investor can make a determination about the property based upon the outcome. When the discounted future benefits are equal to or are greater than what must be paid for those benefits, the rate of return is achieved and the investment opportunity might be worth pursuing. When the present value of the future benefits is less than the cost for those benefits, the rate of return will not be achieved and the property might not be worth further evaluation.

How NPV Helps

Here’s the dilemma real estate investor’s face when doing a real estate analysis on income property addressed by net present value.

At the same time that projections can be for both the capital investment amount and the property’s future benefit, that data alone says nothing about what rate of return is achieved. In other words, the investor, without knowledge of the yield, has no adequate way to compare a specific income property to other potential investment opportunities.

In this case, net present value lets the investor plug in his or her target yield for a property and then reveals whether or not the future cash flow benefits generated by that income property will be enough to achieve that yield based on the capital required to make that investment.

The Formulation

The NPV result is a dollar amount that will either be a negative dollar amount, a zero dollar amount, or a positive dollar amount. Here’s the formulation.

First, NPV arrives at the present value of all the rental property’s future benefits (i.e., cash flows) by discounting them at the real estate investor’s desired rate of return. Then it deducts that amount from the capital required to make that investment.

Examples

Okay, let’s look at the following three examples and then make a determination about the result.

1) Let’s assume that a multifamily property under evaluation requires a $100,000 investment and the present value of all future benefits is $90,000. The result would be -$10,000 (90,000 – 100,000 = -10,000). In other words, since the discounted value of future benefits is less than the amount you must invest, your specified rate of return is not met and therefore you might consider moving on to another property.

2) Say that a commercial office building you’re doing a real estate analysis on is going to take an investment of $500,000 and produces a discounted value of $500,000 for all the future benefits. The result will be $0 (500,000 – 500,000 = 0). In this case, because the present value of future benefits exactly equals the amount of the investment, your desired yield is perfectly met but with no room to spare.

3) Let’s say that an income property you’re analyzing is selling for $750,000 and generates a present value of all future cash flows in the amount of $765,000. The result would be $15,000 (750,000 – 765,000 = 15,000). Therefore, you have a positive dollar amount revealing that your desired rate of return is met with room to spare, and in fact you might have come across a keeper.

The Bottom Line

Of course, NPV is not without its shortcomings because it doesn’t really provide investors with any useful information from a risk perspective. In other words, NPV alone (though it helps compare properties with the same yield requirements) is not going to enable you to compare one investment opportunity to another based upon risk.

Nonetheless, net present value is certainly worth knowing and when properly used as part of a real estate analysis can help you evaluate your next income property investment opportunity. Just bear in mind that it is just one aspect of real estate investing analysis, and should not dictate your investment decision.

One final thought. NPV is impractical to calculate without using a financial calculator or quality real estate investment software. If you are serious about real estate investing then by all means purchase a good real estate software solution that provides net present value along with other real estate analysis features that will benefit you as well.