So if you’ve been around real estate investing for a while, it’s likely that you’ve already seen this return in some of the reports you created for your property evaluation.
If you regularly rely upon one of the better real estate analysis software solutions, than perhaps you saw it in a Pro Forma Income Statement or other revenue report. Fair enough.
However, it’s also true that net present value is one of those illusive returns that some might not understand; nor have any idea how to interpret.
So in this article I will attempt to explain NPV well enough to give you the idea of what it is, and how your understanding may help you make a prudent real estate investment decision.
NPV is the dollar amount difference between the present value (PV) of all future cash flows produced by a rental property and the amount of initial cash investment required to purchase the property (i.e., down payment and closing costs).
- Present Value of all Future Cash Flows
- – Initial Cash Investment
- = Net Present Value
Okay, so let’s step through the process so you understand how the method of arriving at the NPV works.
- The investor applies the rate of of return that he or she desires (e.g., 10%)
- All future cash flows are then “discounted” back at that 10% rate to calculate the sum total of those future cash flows at their “present value”
- Then the initial cash investment required from the investor to purchase the property is subtracted from that sum total of discounted cash flows (their present value)
- The result is net present value (a dollar amount)
- Discount Rate: 10%
- CF#1, CF#2, CF#3, etc. (discounted at 10% to get their present value)
- Total PV of those future cash flows less Initial Cash Investment
We’ll consider two examples in order to arrive at both, a positive NPV dollar amount and a negative NPV dollar amount. Then we can look at what each of those results mean.
1. Let’s say that the present value of all future cash flows expected to be generated by the income property equals $110,000 and the cash investment required to purchase the property is $100,000.
- – 100,000
- = 10,000 (a positive amount)
2. Okay, now let’s say that the initial investment remains at $100,000 but that the present value of all future cash flows is lower at $90,000.
- – 100,000
- = -10,000 (a negative amount)
How to Interpret the Results
- Positive Amount Whenever the NPV is greater than zero, it means that the discounted value of the future cash flows is greater than the initial investment. In other words, you are getting a good deal and getting a rate of return that is actually higher than the discount rate you desire.
- Negative Amount NPV less than zero means the opposite. You are getting a lower rate of return than you desire and not getting the deal you’ve had in mind.
Although it should not be used as the only factor to decide whether a real estate investment provides a good buying opportunity, NPV does provide the real estate investor with a quick and easy way to determine whether the price that will be paid for the property will yield the investor’s desired rate of return (discount rate).
So You Know