Net Present Value (NPV): The Definition and Formula
by James Kobzeff
Any real estate investor who has tried to evaluate the price for a rental property with time value of money consideration has undoubtedly used net present value (NPV).
Although it should not be used as the only factor to decide whether a real estate investment provides a good buying opportunity, NPV does provide the investor with a quick and easy way to determine whether the price that will be paid for the property will yield the investor's desired rate of return (i.e., discount rate).
What is Net Present Value?
NPV is the difference between the present value (PV) of all future cash flows produced by a rental property and the amount of cash investment (or, initial investment; down payment and closing costs) required to purchase the property.
Example. Let's assume that the investor desires a 10% yield on all future cash flows, must invest $100,000 cash to purchase those cash flows, and wants to know whether the price he or she will pay achieves the desired yield. NPV would be calculated in the following manner:
Discount back all future cash flows at 10% (the desired rate of return) to determine the present value (PV) of those future cash flows.
Deduct the investment (or initial investment) of $100,000 from the present value (PV) of those future cash flows.
How NPV Works
NPV will always appear as a dollar amount in one of three ways: greater than zero, zero, or less than zero. We have to examples below that illustrate an amount that is greater than zero and less than zero to give you the idea.
EXAMPLE A: Let's assume that the PV of all future cash flows is $110,000. We would calculate NPV by subtracting $100,000 (the initial investment) from $110,000 (the PV of all future cash flows).
NPV = $110,000 - 100,000 = $10,000
EXAMPLE B: Let's assume that the PV of all future cash flows is $90,000. We would calculate NPV by subtracting $100,000 (the initial investment) from $90,000 (the PV of all future cash flows).
NPV = $90,000 - 100,000 = -$10,000
What it Means
When NPV is greater than zero it means that the discounted value of future cash flows is greater than your initial investment and
you would be getting an even higher return than you desire.
When NPV is zero it means that the discounted value of future cash flows equals your initial investment and
you would be getting exactly the return you desire.
When NPV is less than zero (a negative number) it means that the discounted value of future cash flows is less than
your initial investment and you would be getting a lower return than you desire.
Okay, let's interpret our two examples.
EXAMPLE A: With an NPV of $10,000 (greater than zero) you would be getting a good deal for the property based on your desired yield because you have exceeded it.
EXAMPLE B: With an NPV of -$10,000 (less than zero) you would be paying too much for the property based on your desired yield. You must either buy the property for less or lower your yield if you want to pursue this property.
So You Know
ProAPOD® rental property analysis software computes net present value automatically as you enter the property data, and then recalculates in real time each time you make changes so the reports always reflect the changes.
Feel free to share this article.
