The net present value or NPV is a profitability measurement that is commonly used in real estate investing to help real estate investors evaluate different investment opportunities. Calculating the net present value of an investment property is a simple process if you understand how the formula works. Together with other investment property analysis metrics, calculating the net present value is a crucial step before buying an investment property.
Net Present Value: Definition
Before starting our guide on calculating the net present value of an investment property, it is important that you understand the meaning of this investment property analysis metric. The net present value of an investment property is a measurement that indicates the present value of all future cash flows produced by a rental property minus the initial cash investment required to buy the investment property.
Related: What Are the Most Important Metrics in Real Estate Investment Property Analysis?
Calculating the net present value helps real estate investors determine whether a real estate property will, in fact, yield the rate of return desired at the price an investment property is purchased. Using the net present value formula, all future cash flows anticipated from a rental property are converted to present value cash flows. In other words, the net present value considers the time value of money, which assumes that money in the present is worth more than money in the future. This happens for two reasons, first due to the potential profits that could be made using the same money during the investment period, better known as opportunity cost. While the second is due to inflation. The discount rate element of the net present value formula is a way to account for the time value of money.
Let’s say that you desire a 10% rate of return (investment yield) on your real estate investment; calculating the net present value reveals whether the future cash flows generated by your rental property will, in fact, give you a 10% rate of return. Future cash flows are discounted at the same desired rate of return.
Calculating the Net Present Value: NPV Formula
NPV = (C1/(1+R)^1)+ (C2/(1+R)^2)+ (C3/(1+R)^3)+…+(Cn/(1+R)^n) – C0
Where:
C0: Initial cash investment
C1: Estimated cash flow of year 1
C2: Estimated cash flow of year 2
C3: Estimated cash flow of year 3
Cn: Estimated cash flow of year n, when the investment property is sold. This cash flow includes cash sale proceeds.
n: year
R: Discount rate % (desired rate of return on investment)
The above npv formula is used when calculating the net present value of a real estate investment that generates revenue at varying rates over time. However, if each period generates equal cash flows, then the following net present value formula is used:
NPV = C X {(1-(1+R)^-T)/R} – C0
Where C is the constant cash flow per period, T is the number of periods of the real estate investment and R is the required rate of return.
Calculating the net present value: How it works
1- First, the real estate investor sets a rate of return that he or she desires to make from buying the investment property.
2- Second, using the net present value formula, all future cash flows are discounted to determine the present value of those future revenues. Keep in mind that the cash flow of the “nth” year or last year of holding the real estate investment property includes the sales proceeds of the property.
3- Finally, subtract the initial cash down payment from the total present value of future cash flows.
Calculating the net present value: Interpreting the results
Applying the net present value formula will give you a number which is mathematically a dollar amount and not a percentage rate. The result can be either one of the following amounts.
1- A value less than zero: this means that the discounted present value of future cash flows is less than the initial cash investment, and therefore, you will not achieve the desired rate of return. In other words, you are getting a lower rate of return than you desired.
2- A value equal to zero: this means that the discounted present value of future cash flows is exactly equal to the initial cash investment and therefore, you will achieve exactly the desired rate of return.
3- A value larger than zero: this means that the discounted present value of future cash flows is greater than the initial cash investment and therefore, you will achieve a higher rate of return than desired.
Example of calculating the net present value
Assume you are buying an investment property with an initial cash investment of $25,000 and your desired rate of return on the investment is 10%. The annual cash flows from holding the property for 3 years are equal to $5000, $4000, $6000, and sales proceeds equal to $150,000. Assume you still owe the bank $100,000. Thus, the cash proceeds from selling the investment property after 3 years would be $50,000.
C0= $25,000
C1= $5000
C2= $4000
C3= $6000 + $50,000 = $56,000
Discount future cash flows using npv formula:
DC1 = $4545
DC2= $3306
DC3= $42,074
NPV = $4545 + $3306 + $42,074 – $25,000= $24,925
NPV is greater than zero which means your desired rate of return is achieved.
Calculating the net present value is also used to compare different investment properties. When using the same npv formula to calculate the net present value of different investments, the one with the higher value will yield a higher return at the same discount rate.
Related: The Beginner’s Guide to Rental Property Analysis
The Bottom Line
As stated earlier, calculating the net present value is important to assess the profitability of real estate investments and to help real estate investors decide between different investment opportunities. However, one limitation of NPV is that it doesn’t take into account the timing of cash flows. Two investments, one with a lump sum cash flow in 10 years and another with even cash flows over 10 years would have the same NPV. Therefore, we advise real estate investors to use NPV together with other real estate indicators such as IRR, cash on cash return and cap rate.
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