Understanding Net Present Value: Knowing Whether The Real Estate Investment Achieves Your Desired Yield!
Net present value (or NPV) is a return commonly used in 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 real estate investment.
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.
The dilemma real estate investor’s face when doing a real estate analysis on rental income property is addressed by net present value.
For at the same time that projections can be made for both the capital investment amount and a property’s future cash flow benefit, that data alone says nothing about what rate of return is achieved from that property.
In other words, because the real estate investor has no knowledge of the yield, he or she has no adequate way to compare a real estate investment project 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 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.
Okay, let’s look at the following three examples and then make a determination about the result for each so you understand the concept.
1) Let’s assume that a rental property under evaluation requires a $100,000 investment and the present value of all future benefits discounted at 6% (your desired rate of return) is $106,362. The result would be $6,362 (106,362 – 100,000 = 6,362).
Determination: Since the discounted value of future benefits is more than the amount you must invest, your specified rate of return is met and therefore the rental property might prove to be a profitable real estate investment opportunity.
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).
Determination: Because the present value of future benefits exactly equals the amount of the investment, the office building meets your desired investment yield perfectly but with no room to spare.
3) Let’s say that an apartment complex you’re analyzing is selling for $750,000 and generates a present value of all future cash flows in the amount of $745,000. The result would be -$5,000 ( 745,000 - 750,000 = -5,000).
Determination: You have a negative dollar amount revealing that your desired rate of return is not met with this specific apartment complex and perhaps you should consider moving on to another real estate investment opportunity.
Sample (example 1, above)
Sample (using Excel)
Of course, NPV is not without its shortcomings because it doesn’t really provide real estate 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 real estate 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 simply by knowing the formula (at least for most). So it does require MS Excel, a financial calculator, or other quality real estate solution. If you are serious about real estate investing and want to include net present value in your real estate analysis presentations, however, you probably want to consider real estate investment software with net present value and printable reports.
About the Author
James Kobzeff is a real estate professional and the owner/developer of ProAPOD - leading real estate investment software solutions since 2000. Create cash flow, rates of return, and profitability analysis on rental property at your fingertips in minutes! Includes the NPV calculation.
ProAPOD also provides iCalculator - an online real estate calculator that enables you to learn dozens of real estate definitions and formulas as you calculate, including net present value. You save 64%. Learn more at real estate calculator
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