Net present value (or NPV) is a real estate investing measure widely used by investors in an investment real estate analysis for a specific purpose: Net present value tells the investor whether a property will achieve his or her target rate of return and therefore should attract the investor's capital into that investment.

Here's the technical interpretation.

The net present value model is based on a decision rule that states if the discounted present value of future benefits is equal to or greater than the cost of those benefits it is a profitable opportunity. Whereas, if the present value of the future benefits is less than the cost for those benefits, the rate of return will not be achieved and chances are good that the investor should take another look.

Okay, let's frame the idea with a simple illustration.

When you place your money into a savings account (i.e., invest your capital) you expect it to earn interest (i.e., provide future benefits). The bank dictates the return and you are either willing or unwilling to tie up your capital based upon your acceptance of that return. For example, whereas you might deposit $10,000 to earn 3.8% interest, you might not make the investment to earn 1.2% interest.

Fair enough. But suppose that the bank doesn't quote an interest rate. Only what amount of money you'll be able to collect in the future. Only that next year you will collect $10,300 with a deposit of $10,000 today. If there were no mention of an interest rate, how would you know what yield your investment is earning?

That's the dilemma real estate investors face when analyzing income property. There's a projection for both an investment amount and future benefit, but there's no mention of yield. The investor has no idea what rate of return is achieved based upon that data alone, and therefore no way to compare it to other potential investment opportunities adequately.

This is where net present value comes in.

NPV lets you plug in a target yield for a property and then informs you whether the future cash flows (benefits) generated by that property will be enough to achieve that yield on your capital investment or not.

How It Works

NPV discounts all future cash flows by the desired rate of return to arrive at a present value of those future cash flows and deducts that amount from the initial equity (or capital invested). The result is a dollar amount that will always be either negative, zero, or positive.

How to Interpret

1) Negative dollar amount - This means that the present value of future benefits is less than the amount invested and that the specified rate of return is not met. In other words, you might want to move on to another property.

2) Zero dollar amount – This signifies that the present value of future benefits equals the amount of the investment and that the desired yield is perfectly met. In other words, the property will achieve the return you want but with no room to spare. 

3) Positive dollar amount - This reveals that the desired rate of return is met with room to spare. In other words, you might have come across a keeper.

Net present value is certainly worth knowing, and when properly used can help you evaluate your next real estate investment opportunity.  But bear in mind that it is just one aspect of real estate investing analysis, should not dictate an investment decision, and is not without its shortcomings.

Yes, NPV will provide you the opportunity to evaluate projects using the same rate of return requirements, but it will not provide any useful information concerning one project over another from a risk standpoint.

Finally, I should add that the NPV is practically impossible to calculate without using a financial calculator or quality real estate investment software. If you are serious about real estate investing then it is highly recommended that you make an investment in a good real estate software solution that provides net present value along with other real estate analysis features that will benefit you as well.

Here's to your real estate investing success.