May 19, 2024


Mad about real estate

How Net Present Value Reveals an Investment’s Rate of Return

Net present value (NPV) is a real estate investing measure widely used by investors for investment real estate analysis. It serves a specific purpose. Net present value tells the investor whether the target rate of return will be achieved, and hence, whether the property should attract the investor’s capital into that investment.

The net present value model is based on a decision rule that states if the discounted present value of future benefits is equal to or greater than the cost of those benefits it is a profitable opportunity. Whereas, if the present value of the future benefits is less than the cost for those benefits, the rate of return will not be achieved and chances are good that the investor should take another look.

Here’s a simple illustration to help frame the idea.

When you place your money into a savings account (i.e., invest your capital) you expect it to earn interest (i.e., provide future benefits). The bank dictates the return and you either will or will not desire to tie up your capital depending on your acceptance of that return. For example, whereas you might deposit $10,000 to earn 3.8{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} interest, you might not make the investment for 1.2{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} interest.

Okay, but what if a bank doesn’t quote an interest rate. Let’s say that they tell you only what amount of money you’ll collect in the future. For example, you’re only aware that you will collect $10,300 next year for your deposit of $10,000 today. There’s no mention of interest rate. How would you know what yield your investment is earning?

That’s the dilemma real estate investors face when analyzing income property. Whereas there’s a projection for an investment amount and future benefit, there’s no mention of yield. Based on those numbers alone, the real estate investor has no idea what rate of return is achieved, and therefore no way to compare it to other potential investment opportunities adequately. That’s where net present value comes in.

NPV takes your desired yield and essentially tells you whether the future cash flows (benefits) from a property are going to achieve that yield on your capital investment or not. In other words, you plug in the yield you want, and NPV provides a result that will inform you whether that target yield is achieved.

How It Works

NPV discounts all future cash flows by the desired rate of return to arrive at a present value of those future cash flows, and then it deducts that amount from the initial equity (capital invested).

NPV = Capital investment minus the present value of all future cash flows discounted by the desired rate of return. The result is a dollar amount that is either negative, zero, or positive.

For example, let’s assume an investment of $100,000 and three different results for the present value of all future cash flows: $105,000, $100,000, and $95,000. The NPV for each case would be as follows: -$5,000, zero, and $5,000.

How to Interpret

1) Negative dollar amount – If NPV is a negative dollar amount it means that the present value of future benefits is less than the amount invested and that the specified rate of return is not met. In other words, you might want to keep looking.

2) Zero dollar amount – If NPV is zero, it signifies that the desired yield is perfectly met.

3) Positive dollar amount – If NPV is a positive dollar amount it signifies that the desired rate of return is met with room to spare. In other words, this property is definitely worth further analysis.

Of course, net present value is not without its shortcomings. Whereas NPV provides an investor the opportunity to evaluate projects using the same rate of return requirements, it will not provide any information concerning one project over another from a risk standpoint.

Nonetheless, if used correctly, net present value is certainly worth knowing and in turn computing the next time a real estate investment captures your interest; to your success.