Net present value (NPV) is a measurement of the investment performance of a property that converts investment cash flows to a single amount to facilitate a real estate investor’s decision making for property analysis and comparison purposes. And this true whether the investor is concerned with maximizing wealth at a specific point in time or minimizing the cost of obtaining a particular benefit.
In this article, we define net present value, look at the components required to calculate it, and interpret the results.
Technically, NPV measures the sum of the present values of a property’s future cash flows and reversion netted against the initial investment. In other words, all the future cash flows (including future sales proceeds) you are expecting to receive over the course of owning the income property (the holding period) are discounted back with your designated “discount rate” (rate of return) to calculate the present value of those funds and then subsequently “added” to your initial investment.
Okay, that was a mouthful and perhaps fuzzy, but bear with me. It should become clearer once you understand the components that surround net present value.
- Holding Period – This is specified time you expect to own the investment property i.e., five years, six years, and so on.
- Initial Investment – This is the cost of the investment and typically is the property’s purchase price plus loan points (if any) less the total amount of the loan. For example, if you pay $100,000 for a property and are getting a loan for $80,000 at one loan point, then your initial investment would be $20,800 (price – loan + points).
- Cash Flows – These are the funds projected periodically at the end of each year the property is held and are derived from rental and other income less operating expenses, debt service, and (in the case of cash flow after-tax) taxes.
- Sale Proceeds – This is the amount you are expecting to receive from the sale of the property at the end of the forecast holding period. Sale proceeds are equal to sale price less brokerage commissions and other closing costs, outstanding loan balance(s), and (in the case of sale proceeds after taxes) taxes resulting from the sale.
- Discount Rate – This is the minimum acceptable rate of return that you want to earn from owning the investment property. In other words, if you have the opportunity to make a seven percent return on an alternative investment of similar risk, size, and duration, then you would surely not want to accept a lower rate than seven percent as your discount rate to derive NPV for the property being analyzed.
Okay, let’s look at an example so you can see the procedure taken to calculate net present value. For our purposes we’ll assume just a four-year holding period, but bear in mind that it can encompass any holding period. It should also be stated that the NPV can be used with before or after-tax cash flows and sale proceeds, though most real estate investors would probably include the taxes.
For our example we’ll assume an initial investment of $10,000 and the following periodic cash flows: zero EOY 1, negative $1,000 EOY 2, $4,000 EOY 3, and $6,000 EOY 4 along with sale proceeds of $4,500. Our desired yield (discount rate) will be 7.0%. Here’s the structure:
Year0: (10,000) – initial investment must be shown as a negative
Year4: 10,500 – the cash flow plus sales proceeds
Now the calculation: discount each cash flow in Years 1-4 back to Year 0 at 7.0% and “add” that amount to the initial investment to determine NPV. Here’s the result: (10,000) + 10,402.15 = 402.15.
This means that the present value of cash flow benefits for this investment property exceeds our initial investment by $402.15. In other words, according to our net present value we can pay as much as $10,402.15 ($10,000 + $402.15) for this rental property and earn our required 7% rate of return. Likewise, a negative NPV in this case would have indicated that the future cash flows from this investment are not sufficient to yield the 7% rate of return required and the investor could pay no more than $9,597.85 ($10,000 – $402.15) in order to earn the required 7% rate of return.