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NPV - Net Present Value
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.
For 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.
Here's to NPV Works
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). The NPV is $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). The NPV is -$10,000.
How to Interpret NPV
NPV will always appear as a dollar amount in one of three ways: greater than zero, zero, or less than zero. Here's how to interpret it.
When NPV is greater than zero it means the discounted value of future cash flows is greater than the initial investment. You are getting an even higher return than you desire. You can pay $10,000 more for the property and still achieve your desired return When NPV is zero it means the discounted value of future cash flows is equal to the initial investment. You are getting exactly the return you desire. The price for the property is exactly right. When NPV is less than zero (a negative number) it means the discounted value of future cash flows is less than the initial investment. You are getting a lower return than you desire. You must pay $10,000 less for the property to achieve your desired return.
Okay, let's interpret our two examples.
Example A has an NPV of $10,000 (greater than zero). You are getting a good deal for the property based on your desired yield. You can even pay $10,000 more for the property and still achieve your yield.
Example B has an NPV of -$10,000 (less than zero). You are paying $10,000 too much for the property based on your desired yield. You must either buy the property for $10,000 less or lower your yield.
ProAPOD® Real Estate Investment Software 10.0 and Real Estate Investor Software 4.0 each calculate Net Present Value (NPV) automatically once you enter the property data and investor's discount rate. The net present value is recalculated each time you make changes to the property data and discount rate. Reports such as the proforma income statement and assumptions report reflect NPV.
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