Using Net Present Value to Make an Investment Decision
Net present value (NPV) can be helpful to a real estate investor trying to decide whether or not it makes sense to buy a particular multifamily income property at a given price. Let’s take a look.
If you read our earlier discussion on present value (PV) and discounted cash flow, you recall that when you discount all future cash flows of a rental income property at a given rate of return, you can determine the present value of those cash flows. The concept concerns the time value of money. That is to say, having $100 today is preferrable to having that same amount one year, or five years from now. Inflation erodes purchasing power over time, income taxes might be higher, and (let’s face it) you might not live that long. It’s always a good idea, therefore, that investments in real estate be studied from a time value of money standpoint because the timing of cash flows from the investment might be more important than the amount received. But present value (though it tells you what the future cash flows are worth today) doesn’t necessarily say how much you are going to pay for those future cash flows. This is where net present value comes in.
Net present value is the difference between the sum of the PV of all future cash flows and the amount of cash you are going to invest to purchase those cash flows (thus, the name, “net” present value). For example, if the PV of all future cash flows is $100,000 and you’re planning to invest $90,000 to buy the rental property that generates those cash flows, the NPV would be $10,000 (100,000 - 90,000 = 10,000). On the other hand, if the PV of all future cash flows is $100,000 and you’re planning to invest $110,000 to buy the rental property that generates those cash flows, the NPV would be -$10,000 (100,000 - 110,000 = -10,000).
We’ll discuss what it means when the PV of cash flows are less or more than the amount of your investment next time. For now just keep in mind that NPV is used by investors to measure how much must be paid to receive a stream of future cash flows at a specified rate of return. Stay tuned.
