The facts about net present value from A to Z
Net Present Value (NPV) is a measure of a property’s investment performance that converts the investment cash flows into a single amount to facilitate a real estate investor’s decision-making for analysis and comparison purposes. the property. And this is true whether the investor is interested in maximizing wealth at a specific time or minimizing the cost of making a particular profit.
In this article, we define net present value, look at the components needed to calculate it, and interpret the results.
Technically, the NPV measures the sum of the present values of a property’s future cash flows and the net reversal against the initial investment. In other words, all future cash flows (including future sales income) that you expect to receive during the course of income ownership (the holding period) are discounted at your designated “discount rate” (rate of return). to calculate the present value of those funds and then “added” to your initial investment.
Okay, that was a mouthful and maybe confusing, but bear with me. It should become clearer once you understand the components surrounding net present value.
- Tenure Period: It is the specified time in which you expect to own the investment property, that is, five years, six years, etc.
- Initial Investment – This is the cost of the investment and is typically the purchase price of the property plus the loan points (if any) minus the total loan amount. For example, if you pay $ 100,000 for a property and borrow for $ 80,000 at one loan point, then your initial investment would be $ 20,800 (price – loan points).
- Cash Flows – These are the funds projected periodically at the end of each year the property is held and are derived from rent and other income less operating expenses, debt service, and (in the case of cash flow after tax) tax.
- Proceeds of sale – This is the amount you expect to receive from the sale of the property at the end of the expected waiting period. The sale proceeds are equal to the sale price less brokerage fees and other closing costs, outstanding loan balances, and (in the case of after-tax sale proceeds) taxes resulting from the sale.
- Discount Rate – This is the minimum acceptable rate of return you want to earn by owning the investment property. In other words, if you have the opportunity to earn a seven percent return on an alternative investment of similar risk, size, and duration, you probably don’t want to accept a rate lower than seven percent as your discount rate to derive the NPV for the investment. property being analyzed.
Okay, let’s look at an example so you can see the procedure that was followed to calculate the net present value. For our purposes, we will assume only a four-year holding period, but please note that it can span any holding period. It should also be noted that NPV can be used with pre-tax or after-tax cash flows and sale proceeds, although most real estate investors would likely include taxes.
For our example, we will assume an initial investment of $ 10,000 and the following periodic cash flows: zero EOY 1, negative $ 1,000 EOY 2, $ 4,000 EOY 3, and $ 6,000 EOY 4 along with sales income of $ 4,500. Our desired return (discount rate) will be 7.0%. This is the structure:
Year0: (10,000) – initial investment should be shown as a negative value Year1: 0 Year2: (1,000) Year3: 4,000 Year4: 10,500 – cash flow plus sales revenue
Now the calculation: discount each cash flow in years 1-4 to year 0 at 7.0% and “add” that amount to the initial investment to determine the NPV. Here is the result: (10,000) 10,402.15 = 402.15.
This means that the present value of the cash flow benefits for this investment property exceeds our initial investment by $ 402.15. In other words, based on our net present value, we can pay up to $ 10,402.15 ($ 10,000 $ 402.15) for this rental property and earn our required 7% rate of return. Likewise, a negative NPV in this case would have indicated that the future cash flows from this investment are not sufficient to produce the required 7% rate of return and the investor would not be able to pay more than $ 9,597.85 ($ 10,000 – $ 402.15) for to obtain the required rate of return of 7%.