What is Net Present Value and Why Do Real Estate Investors Care?

jim kobzeff

by James Kobzeff
Mar 23, 2018

Though net present value is a measurement commonly used by real estate investors 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, it's not as commonly understood.

So it seemed needful to discuss it.

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.

In other words, it converts all future cash flows a property might generate and converts it into what that total amount is worth in today's dollars. The process is known as the time value of money.

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

Example

You're considering the purchase of a rental income property and want to calculate the NPV to see whether it will achieve your desired 10% rate of return in three years based upon your following estimations: an initial cash investment of $100,000, annual cash flows of $3,000, $4,000, $5,000, and cash proceeds of $130,000 generated from a sale of the property in three years.

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

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

STEP FOUR Since the resulting dollar amount for NPV will fall into one of the three following categories, apply the NPV computed above to the table below to determine whether or not your desired rate of return is achieved:

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

RESULT Your computed net present value of $107,460.56 is greater than zero, therefore your desired rate of return is achieved (and exceeded).

So You Know

ProAPOD Pro RE Calculator includes a net present value calculator in its suite of online real estate calculators so you can make the computation very easily. ProAPOD Executive 10 software also computes NPV and posts the result in the appropriate investment property analysis reports it creates automatically.

james kobzeff author

James Kobzeff is a former realtor with over thirty years of investment property experience and is the owner/developer of ProAPOD Real Estate Software.