The Facts About Net Present Value From A to Z
Net present value (NPV) is a measurement of the investment performance of a character that converts investment cash flows to a single amount to ease a real estate investor’s decision making for character examination and comparison purposes. And this true whether the investor is concerned with maximizing wealth at a specific point in time or minimizing the cost of obtaining a particular assistance.
In this article, we define net present value, look at the elements required to calculate it, and interpret the results.
Technically, NPV measures the sum of the present values of a character’s future cash flows and reversion netted against the initial investment. In other words, all the future cash flows (including future sales proceeds) you are expecting to receive over the time of owning the income character (the holding period) are discounted back with your designated “discount rate” (rate of return) to calculate the present value of those funds and then afterward “additional” to your initial investment.
Okay, that was a mouthful and perhaps fuzzy, but bear with me. It should become clearer once you understand the elements that surround net present value.
- Holding Period – This is stated time you expect to own the investment character i.e., five years, six years, and so on.
- Initial Investment – This is the cost of the investment and typically is the character’s buy price plus loan points (if any) less the total amount of the loan. For example, if you pay $100,000 for a character and are getting a loan 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 regularly at the end of each year the character is held and are derived from rental and other income less operating expenses, debt service, and (in the case of cash flow after-tax) taxes.
- Sale Proceeds – This is the amount you are expecting to receive from the sale of the character at the end of the forecast holding period. Sale proceeds are equal to sale price less brokerage commissions and other closing costs, noticeable loan balance(s), and (in the case of sale proceeds after taxes) taxes resulting from the sale.
- Discount Rate – This is the minimum permissible rate of return that you want to earn from owning the investment character. In other words, if you have the opportunity to make a seven percent return on an different investment of similar risk, size, and duration, then you would surely not want to accept a lower rate than seven percent as your discount rate to origin NPV for the character being analyzed.
Okay, let’s look at an example so you can see the procedure taken to calculate net present value. For our purposes we’ll assume just a four-year holding period, but bear in mind that it can include any holding period. It should also be stated that the NPV can be used with before or after-tax cash flows and sale proceeds, though most real estate investors would probably include the taxes.
For our example we’ll assume an initial investment of $10,000 and the following regular cash flows: zero EOY 1, negative $1,000 EOY 2, $4,000 EOY 3, and $6,000 EOY 4 along with sale proceeds of $4,500. Our desired provide (discount rate) will be 7.0%. Here’s the structure:
Year0: (10,000) – initial investment must be shown as a negative Year1: 0 Year2: (1,000) Year3: 4,000 Year4: 10,500 – the cash flow plus sales proceeds
Now the calculation: discount each cash flow in Years 1-4 back to Year 0 at 7.0% and “add” that amount to the initial investment to determine NPV. Here’s the consequence: (10,000) 10,402.15 = 402.15.
This method that the present value of cash flow benefits for this investment character exceeds our initial investment by $402.15. In other words, according to our net present value we can pay as much as $10,402.15 ($10,000 $402.15) for this rental character 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 provide the 7% rate of return required and the investor could pay no more than $9,597.85 ($10,000 – $402.15) in order to earn the required 7% rate of return.