How Net Present Value Assesses Investment Property Price
Net Present Value (or NPV) is a real estate investment measure widely used by investors in investment real estate analysis for a specific purpose: Net Present Value tells the investor whether a property will meet its rate of return. objective and therefore should attract the investor’s capital in that investment.
Here is the technical interpretation.
The net present value model is based on a decision rule that states that 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 future benefits is less than the cost of those benefits, the rate of return will not be achieved and the investor will most likely need to look again.
Well, let’s frame the idea with a simple illustration.
When you put your money in a savings account (that is, invest your principal), you expect it to earn interest (that is, provide future benefits). The bank dictates the return and you are willing or unwilling to immobilize your capital depending on your acceptance of that return. For example, while you may deposit $10,000 to earn 3.8% interest, you may not invest to earn 1.2% interest.
Fair enough. But suppose the bank does not quote an interest rate. Just how much money you will be able to collect in the future. Only next year you will collect $10,300 with a deposit of $10,000 today. If no interest rate was mentioned, how would you know what return your investment is getting?
That’s the dilemma real estate investors face when looking at rental properties. There is a projection for both the investment amount and the future benefit, but the yield is not mentioned. The investor has no idea what rate of return is achieved based on that data alone, and therefore no way to properly compare it to other potential investment opportunities.
This is where net present value comes in.
NPV allows you to plug in a target return for a property and then tells you whether or not the future cash flows (earnings) generated by that property will be enough to achieve that return on your capital investment.
How does it work
NPV discounts all future cash flows by the desired rate of return to arrive at a present value of those future cash flows and deducts that amount from the initial capital (or capital invested). The result is a dollar amount that will always be negative, zero, or positive.
How to interpret
1) Negative dollar amount – This means that the present value of future benefits is less than the amount invested and the specified rate of return is not achieved. In other words, you may want to move to another property.
2) Zero dollar amount – This means that the present value of future benefits is equal to the investment amount and the desired return is perfectly met. In other words, the property will achieve the performance you want but with no room to spare.
3) Positive dollar amount – This reveals that the desired rate of return is being met with room to spare. In other words, you may have met a guardian.
Knowing net present value is certainly worth knowing, and when used correctly can help you evaluate your next real estate investment opportunity. But keep in mind that it is only one aspect of real estate investment analysis, it should not dictate an investment decision, and it is not without its shortcomings.
Yes, NPV will give you the opportunity to evaluate projects using the same rate of return requirements, but it will not provide any useful information about one project over another from a risk standpoint.
Finally, I must add that the NPV is not practical to calculate without using a financial calculator or quality real estate investment software. If you are serious about investing in real estate, by all means invest in a good real estate software solution that provides net present value along with other real estate analysis features that will also benefit you.
Here’s to your success in real estate investing.