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What Is NPV in Real Estate? An Investor's Guide

Net present value, or NPV, can be used to help compare cash-flowing investments by values over time, today.

[Updated: Feb 04, 2021] Jan 12, 2021 by Liz Brumer
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In the finance and real estate world, the term net present value (NPV) is used to help investors understand the value of money in an investment over time. If you're investing in cash flow real estate, learn what NPV is, how the net present value calculation works, and how the net present value method is used in real estate.

What is NPV?

Net present value is a formula that allows investors to determine the value of an investment today despite the investment earning income over time through residual cash flow. The NPV calculation takes into account all income, revenues, and expected cash inflow after expenses earned over the life of an investment with a discount rate that takes into account inherent risks of the investment as well as time. Ultimately, it helps investors compare different investments by looking at the present value of their money today, their initial investment, and comparing to the present value of their money in the future, the projected cash flow with the discount rate.

Why use NPV?

The value of money is constantly changing. Thanks to inflation, money today will always be more valuable than money in the future, meaning loans or other investments that provide a consistent or identical income stream over time can be difficult to calculate a value or return on. The NPV method reflects the value of money in the investment over time in today's value, where each future cash flow over the repayment period decreases in value slightly to reflect the cost of inflation and time.

What is the NPV calculation?

Luckily, for those who aren't well-versed in computing complex calculations without assistance from a calculator or spreadsheet, there are plenty of free calculators or tools online that will help you calculate the net present value of an investment opportunity. There is even an Excel NPV function that can quickly calculate the NPV of an investment directly in a spreadsheet, which is especially helpful for investments with uneven cash flow.

But for those who want to know how the NPV formula works, the NPV calculation is as follows:

NPV valuation.jpg

Click to enlarge

i = discount rate, which is the rate of return that could be earned with a similar investment

t = time for payback period of expressed cash flows

The goal is to achieve a positive net present value. The higher the NPV, the better the return for time value when compared to lower NPV investments. If the result is a negative NPV, it's an indicator the investment would lose the company or investor money rather than make money over time.

How is NPV used in real estate?

NPV is used in real estate to help investors make informed decisions when comparing one cash-flowing investment to an alternative investment. For example, if an investor has $150,000 they would like to invest and can either lend the money to a private investor in the form of a private loan or buy a rental property with cash, the investor can use NPV to compare the profitability of each investment's cash flow using present value to see which provides a better return for their money in present value.

Let's say the rental property would produce a target annualized rate of return of 12%, or $1,500 in cash flow per month and $18,000 per year after expenses. The investor expects to hold the rental property for 10 years but can raise rents in year three, producing $18,500 of rental income per year, and again in year seven to $19,000. This would provide a NPV of $17,500.

Here's how it would look on my 10bii NPV calculator:

  • Number of payments per year: 12
  • Amount: $-150,000 Initial Cash Flow
  • Amount: $18,000 # Times: 2
  • Amount: $18,500 # Times: 3
  • Amount: $19,000 # Times: 4
  • NPV: $17,500.00

The private loan would charge an interest rate of 9% amortized over 10 years, with a balloon at the end of year five. The monthly principal and interest payment would be $1,900.14 or $22,801.68 per year, with a balloon payment of $91,535.77 on month 60. This would provide an NPV of $55,544.17.

Here's how it would look on my 10bii NPV calculator:

  • Number of payments per year: 12
  • Amount: $-150,000 Initial Cash Flow
  • Amount: $22,801.68 # Times: 5
  • Amount: $91,535.77 # Times: 1
  • NPV: $55,544.17

Despite the rental property having a better cash-on-cash annualized return on investment (ROI), when it comes to net present value and the return of future cash inflows for the capital investment, the private loan would be a better investment.

Things to keep in mind when using net present value

Net present value analysis isn't perfect. The investor must be fairly confident they can achieve the expected cash flow and have accurately adjusted for risks. Unknown market factors that exceed original expectations make the original NPV calculation obsolete.

Net present value also doesn't take into account other benefits that may relate to the opportunity, such as the tax benefits of owning rental real estate or the ability to own a property that could appreciate over time rather than owning a mortgage loan that depreciates with each loan payment received. Net present value is simply one tool that can be used to analyze and compare real estate or other investments.

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