Net Present Value (NPV) is a measure of a property’s investment performance that converts investment cash flows into a single quantity to aid a real estate investor’s decision making for property comparison and analysis purposes. And this is true whether the investor is interested in maximizing wealth at a specific time or in minimizing the cost of earning a particular benefit.
In this article, we define net present value, discuss the components needed to calculate it, and interpret the results.
Technically, the NPV measures the sum of the present values of a property’s future cash flows and the net reversal against the initial investment. In other words, all future cash flows (including future sales proceeds) that you expect to receive during the course of owning the income property (the holding period) are discounted at your designated “discount rate” (the of return) to calculate the present value of those funds and then “add on” to your initial investment.
Okay, that was a mouthful and perhaps confusing, but bear with me. It should become clearer once you understand the components surrounding net present value.
- Holding Period – This is the specified length of time you expect to own the investment property, i.e. five years, six years, etc.
- Initial Investment – This is the cost of the investment and is typically the purchase price of the property plus loan points (if applicable) minus the total amount of the loan. For example, if you pay $100,000 for a property and take out a loan of $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 owned and derived from rent and other income less operating expenses, debt service, and (in the case of cash flow after taxes) taxes.
- Sale Proceeds – This is the amount you expect to receive from the sale of the property at the end of the intended holding period. The proceeds of the sale equal the sale price less brokerage commissions and other closing costs, outstanding loan balance(s), and (in the case of the proceeds of the sale after taxes) any taxes resulting from the sale.
- Discount Rate – This is the minimum acceptable rate of return you want to earn from owning the investment property. In other words, if you have the opportunity to earn a 7 percent return on an alternative investment of similar risk, size, and duration, you probably don’t want to accept less than 7 percent as your discount rate to get the NPV of the investment. property being analyzed.
Well, let’s look at an example so you can see the procedure followed to calculate the net present value. For our purposes, we’ll assume a four-year holding period, but keep in mind that it can span any holding period. It should also be noted that NPV can be used with pre-tax or after-tax cash flows and sales profits, although most real estate investors would likely include 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 return (discount rate) will be 7.0%. Here is the structure:
Year 0: (10,000) – Initial investment should be shown as negative Year 1: 0 Year 2: (1,000) Year 3: 4,000 Year 4: 10,500 – Cash flow plus sales revenue
Now the calculation: discount each cash flow in years 1-4 to year 0 at 7.0% and “add” that amount to the initial investment to determine the NPV. This is the result: (10,000) 10,402.15 = 402.15.
This means that the present value of the cash flow benefits of this investment property exceeds our initial investment by $402.15. In other words, based on our net present value, we can pay up to $10,402.15 ($10,000 $402.15) for this rental property and earn our required rate of return of 7%. Likewise, a negative NPV in this case would have indicated that the future cash flows from this investment are not sufficient to produce the required 7% rate of return and the investor could not pay more than $9,597.85 ($10,000 – $402.15) to earn the se requires a 7% rate of return.
