Net present value (NPV) is a real estate investing measure widely used by real estate investors for real estate investment analysis.
It’s doubtful whether any prudent real estate investor has ever made an investment decision based on net present value alone, but NPV does provide one aspect of the analysis process that can be helpful when an investor is considering an investment opportunity.
In essence, NPV lets the investor know whether the investor’s target rate of return will be met, and hence, whether the property should attract that investor’s capital into that investment.
The net present value model is based on a decision rule that states if the discounted present value of future benefits is equal to or greater than the cost of those benefits it is a profitable opportunity. Whereas, if the present value of the future benefits is less than the cost for those benefits, the rate of return will not be achieved and chances are good that the investor should take another look.
Consider a simple illustration.
When you place your money into a savings account (invest your capital) you expect it to earn interest (provide future benefits). The return is dedicated by the bank, but based on those benefits you’re willing to tie up your capital because you accept the rate of return.
Okay, suppose, however, that the bank doesn’t quote a rate and instead projects what you might receive in future benefits. In this case, you would have to decide on an acceptable rate and determine whether those future benefits live up to it.
Likewise, the net present value approach to investment value takes your desired rate of return and tells you if a property’s future cash flows (benefits) achieve that yield or not.
Net present value is modeled this way. It discounts all future cash flows by the desired rate of return to arrive at a present value (today’s value) of those cash flows and deducts it from the investor’s initial equity (capital invested today). The result, either, is a negative dollar amount, zero, or a positive dollar amount.
The interpretation is straightforward. If NPV is a negative dollar amount it means that the present value of future benefits is less than the amount invested; the specified return (IRR) is not met.
If NPV is zero, or a positive dollar amount, it signifies either that the desired rate of return (IRR) is perfectly met, or that it is met with room to spare.
The NPV method of investment analysis is informative as it provides an investor the opportunity to evaluate projects using the same rate of return requirements. It will not provide any information concerning one project over another from a risk standpoint, however.
NPV is just one aspect of real estate investing analysis, and not without its shortcomings. Still, if used correctly, one certainly worth knowing about and computing for the next time a real estate investment captures your interest.
