How to Compute Net Present Value

jim kobzeff


June 2, 2015

Net Present Value is a measurement real estate investors commonly use when real estate investing to help them determine whether a rental income property will in fact yield the investor's desired rate of return at the price they may have to pay to purchase the investment.

In layman's terms, Net Present Value (or NPV) is the dollar amount difference between the present value of all future cash flows anticipated from the investment and the cash amount required to purchase those cash flows.

Here's how it works.

  1. The investor establishes a rate of return that he or she desires to make on the investment
  2. All future cash flows expected from the property are discounted at that desired rate to compute the total present worth of those future revenues
  3. The amount of initial cash investment is computed by adding the amount of cash down payment to the total amount of closing costs associated with the acquisition
  4. The total present worth of all future revenues is subtracted from the amount of the total initial cash investment

Formulation

  1. Net Present Value = Present Value of Future Cash Flows less Initial Cash Investment

Example

Let's assume that you're considering a rental property that would require a $100,000 cash investment and is expected to produce three annual cash flows of 3,000, 4,000, and 5,000 along with cash proceeds of 130,000 you estimate will be generated from a sale of the property in three years. You want to know whether making this capital investment will achieve your desired 10% rate of return by computing NPV.

Here's how to do it.

STEP ONE: Create the schema

  1. CFO 100,000
  2. CF1 3,000
  3. CF2 4,000
  4. CF3 5,000 + 130,000 (combined cash flow and sales proceeds)
  5. -adjusted-
  6. CFO 100,000
  7. CF1 3,000
  8. CF2 4,000
  9. CF3 135,000

STEP TWO: Compute the present value of all future cash flows by discounting them back to CFO at 10%

  1. CFO 107,460.56
  2. CF1 0
  3. CF2 0
  4. CF3 0

STEP THREE: Compute Net Present Value by deducting the initial cash amount from the present worth of all future cash flows

  1. 107,460.56 less 100,000 = $7,460.56

Result

The dollar amount for NPV will fall into one of the three following categories. Apply the NPV computed above to the table below to determine your result.

  • Negative - The desired yield is not achieved
  • Zero - The desired yield is exactly achieved
  • Positive - The desired yield is exceeded

In this case, the net present value computed above is greater than zero therefore your desired rate of return is achieved and exceeded.

So You Know

Net present value is automatically computed in ProAPOD's Executive 10 real estate software solutions as well as in iCalculator, it's suite of online real estate calculators.

james kobzeff author

James Kobzeff
Jim is a former realtor with over thirty years real estate investment property experience. He is the developer of ProAPOD's rental property investing software solutions.