In real estate, the net present value of future cash flows is one of the many calculations that a real estate investor can make to decide between different real estate investment opportunities. NPV is not a calculation that can be done on the back of a napkin, but if you understand how it works, you can simply use an NPV software or even an excel spreadsheet.
Definition of Net Present Value
Net present value is really precisely what it sounds like. It is a real estate measure to calculate the present value of your NET future cash flows from real estate property investing. It is widely used in investment real estate analysis as a base to determine if the future cash flows expected to be generated from a rental property have a present value larger than the amount of cash required to invest in the rental property.
In simpler words, the net present value informs the real estate investor whether his or her target rate of return will be achieved, and thus, whether the investor should invest in that property. You can see why it is popular among investors, as their main concern is to make money from real estate properties.
How Net Present Value Serves Investors
When real estate investors are evaluating an investment opportunity, they are faced with a dilemma – how would they know what yield their investment is earning, and whether or not to make the investment?
Average investment property calculators offer real estate investors an estimation of future benefits; however, they don’t mention yield. As a result, real estate investors have no idea what rate of return they might achieve. They also have no way to adequately compare it to other potential investment opportunities.
Here’s where the net present value comes in. Based on your desired rate of return, the NPV basically tells you if future cash flows (benefits) from a property will achieve that yield on your investment or not. In other words, just plug in the yield you want and NPV will provide you with a result which will inform you whether or not that target yield is achieved.
Calculating Net Present Value of Cash Flows
To arrive at a present value of future cash flows, NPV discounts all future cash flows by the desired rate of return and then deducts that amount from the initial cash (capital) invested. The formula for calculating the net present value of cash flows is as follows:
NPV= ∑_(t=1)^N (C_t/(1+r)^t) -NCF_0
N = The total number of years (holding period)
t = Time
Ct = Cash Flow generated at a specific time
r: Discount rate of return
NCF0 = Initial Cash invested
How Net Present Value Works
The net present value calculation is centered on a rule which states: if the present value of future benefits is greater than or equal to the cost of those benefits, then the real estate investor should consider the investment opportunity to be a profitable one. Alternatively, if the present value of the future benefits is less than the cost for those benefits, then it’s best for the investor to consider another investment opportunity because the desired rate of return will not be achieved.
Let’s suppose that a real estate investor aiming to make money from real estate is comparing three separate investment opportunities, each one requiring an investment of $100,000. Based upon the present value of each of the future cash flows, the result is $105,000, $100,000, $95,000 respectively. The net present value for each of these investment properties would be:
- (100,000 – 105,000) = -$5,000: The negative dollar amount means that the present value of future benefits is less than the amount invested, and that the specified rate of return is not met, and thus you’re getting a lower rate of return than you desired.
- (100,000 – 100,000) = 0: The zero dollar amount signifies that the desired yield is exactly equal to your initial investment, and thus you’re getting the return you desired exactly.
- (100,000 – 95,000) = $5,000: The positive dollar amount signifies that the desired rate of return is met, and thus you’re getting a higher rate of return than you desired.
Choosing a Discount Rate
The discount rate is the rate at which future cash flows will be discounted back to a present value. In general, the larger the chosen discount rate, the smaller the present value this will calculate.
There are a number of ways for a real estate investor to choose a discount rate. The most common one is based on a certain rate of return you demand to get on your investment property. When choosing a discount rate in this way, if the net present value calculation is positive, it means that the real estate investment opportunity will generate a rate of return equal to or larger than the chosen discount rate.
Keep in mind that in order to compare different investment opportunities, real estate investors need to use the same discount rate for each one, and the investment with the largest calculated net present value is the best real estate investment.
However, this is the first challenge with this calculation – NPV relies heavily on multiple assumptions and estimates, so there can be considerable room for error.
In addition, discount rates and cash inflow estimates don’t account for risks associated with the investment. So, it might be needed to adjust these factors to account for unexpected costs or losses.
Difference between Net Present Value and Internal Rate of Return
You might be wondering “what’s the difference between NPV and IRR?” As shown in the formula above, the net present value formula measures the present value of cash flows given a discount rate. The internal rate of return, on the other hand, measures a rate of return when setting the NPV to zero.
So, the IRR answers the question “what rate of return will I achieve, given the following cash flows?”, while the NPV answers the question “what is the following cash flows worth at a particular discount rate, in today’s dollars?” In simpler words, the net present value is a dollar amount, while the IRR is a percentage rate.
As mentioned earlier, the net present value calculation is commonly used in real estate investing by investors and analysts who want to evaluate real estate investment opportunities. It offers investors aiming to make money from real estate properties a quick and easy way to determine whether a property might yield the investor’s desired rate of return. You can make your own calculations for net present value on Excel, with some real estate investment software, or with the help of a real estate professional who understands real estate investing. For more information regarding the real estate market, check out our Mashvisor blogs that answer different real estate questions.