What is Net Present Value in Real Estate?
Posted: February 15, 2019 by Mikayla Zimmerman
As a commercial real estate investor, you need to know whether your investment is meeting your financial goals. That’s where Net Present Value comes in. NPV is widely misunderstood, so let’s get a handle on what it means and how it can help you make knowledgeable decisions about your property investments.
Understanding net present value (NPV)
NPV is a calculation that allows investors to clearly see whether their investment is reaching their target yield. It also figures in the adjustment that must be made to the initial investment to reach that financial target, with all other factors staying the same.
A complex-looking equation is used to reach this conclusion.
C: sum of cash flows
n: each period
N: holding period
r: target yield
Though this formula appears complicated, the thinking behind NPV can be expressed simply. NPV equals the present value, minus the cost. The formula tells you whether the property you are purchasing is worth more, less or exactly what you are paying for it.
Understanding the concept behind NPV
When it comes to NPV, the concept is that money you have now is more valuable than money you may have later. It makes sense; after all, if you have money now, you can invest it now to generate a profit, yet if you won’t have that money for a few years, you lose opportunities to earn income during that time. This concept is known as the time value of money, or TVM.
Positive, negative and zero NPV
Simply put, if a property’s NPV is positive, a commercial real estate investor is paying less for the investment than it is worth. An NPV of zero means the investors is buying the property for exactly what it is worth, and if the NPV is negative, of course the investor is purchasing the property for more than it is actually worth.
It’s important to note that NPV does not adjust for cash flows that are uneven; it assumes everything remains the same.
Understanding the internal rate of return
Internal rate of return or IRR determines the rate of return on each dollar invested for each period it is invested. It is different than NPV in that it sets the NPV equation to zero and solves instead for the rate of return. It’s valuable because it allows investors to determine other investments based on their yield.
NPV: A valuable tool for investors
The NPV is an incredibly valuable tool for investors. It can be used in many applications, including comparing lease alternatives, analyzing leasing versus buying and determining whether it’s better to continue owning a property or sell and lease back the space. Overall, it’s a seemingly complex formula that can simplify the decision-making process for investors, which is what makes it so important to understand what NPV is and how it can work for you.