Net present value (NPV) is one of many real estate investing measures real estate investors routinely examine in a real estate analysis to make real estate investment decisions.
Most prudent real estate investors would not typically base their investment decision on net present value alone, but it does contribute an aspect to the analysis process that can be beneficial for investors.
In this article, we’ll look at this real estate investing measure to give you an idea about its purpose as well as an explanation about how to interpret the results when you come across it in a real estate analysis.
Purpose
NPV lets the investor know whether the investor’s target rate of return will be met by the property and therefore should attract that investor’s capital into that investment.
Think of it this way.
You make the decision to invest your capital into (say) a savings account because you accept the interest rate you can earn from the bank on that investment over the course of that account.
The net present value approach to investment value is somewhat the same idea. But in this case, it tells real estate investors whether a property’s future cash flows will achieve the rate of return “they desire” to make the investment.
Model
Net present value is modeled this way. It discounts all future cash flows by the investor’s desired rate of return to arrive at a present value (today’s value) of those cash flows. Then that amount is deducted from the initial equity (capital investment) made by the investor for an acquisition.
The result will be a dollar amount that is either negative, zero, or positive.
Interpretation
- a negative amount means that the investor’s rate of return was not met
- a zero amount means that the investor’s rate of return was met exactly
- a positive amount signifies that the investor’s desired rate of return is met with room to spare
Example
Say you are about to invest $100,000 to purchase a rental income property. You estimate that it will produce annual cash flows over the next five years in the amounts of 2000, 2100, 2200, 2300, 2400, and 2500 along with 130,000 from a sale at the end of five years. Your desired rate of return for all those future benefits is 5.0%.
All future cash flows (including the cash proceeds from the sale) are discounted back at 5.0% and then deducted from the initial cash investment.
Source: iCalculator by ProAPOD
Result
Based upon your cash flow projections and desired rate of return, the rental income property will be a profitable investment because the difference between the initial investment and PV of future cash flows is a positive dollar amount. That is, the value of all future income produced by the property in today’s dollars exceeds the investor’s cash investment.
Summary
Net present value is just one aspect of a real estate investing analysis – and does have some shortcomings. It will not provide any information concerning one project over another from a risk standpoint, for instance.
Still, if used correctly, it can be informative enough to provide real estate investors with the opportunity to evaluate several projects using the same rate of return requirements.
