Rational investors are seeking to grow their assets over time, and assessing the time value of money is an essential step when evaluating different investment opportunities. Net present value (NPV) allows investors to include the time value of money in property valuations. It’s a must-know number when evaluating a commercial real estate property or portfolio.
What is Net Present Value (NPV)?
Net present value is a financial method used to evaluate the profitability of an investment by calculating the present value of future cash flows in today’s dollars. In simpler terms, NPV tells you how much an investment is worth today, based on the expected cash flows it will generate in the future.
NPV takes into account the time value of money. Money today is worth more than the same amount of money in the future, due to inflation and the opportunity cost of not having the money available for other investments.
What is NVP in Commercial Real Estate?
For commercial real estate investors who want a certain yield (return) on their investment, net present value can show whether the target yield is being achieved. Commercial property net present value takes into account the target yield and a property’s net cash flows, in order to give a present value.
In this manner, real estate investors can use NPV to evaluate their current holdings. The calculation shows how well those holdings are performing in light of an investor’s own goals. NPV can thus be used to assess the suitability of properties, and also to compare properties against one another.
The same NPV calculation is made to evaluate the suitability of a potential investment property. It can show whether a property meets target yield requirements, and how a property’s value would compare to current holdings within a portfolio.
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What is the Time Value of Money?
The time value of money is a foundational concept around which NPV is calculated. It takes into account the present value of a cash flow that’s in the future.
The time value of money is the principle that money today is worth more than the same amount of money in the future. Money loses value due to two factors: inflation erodes the raw value of money, and opportunity cost reduces value after opportunities are gone. Each of these can be demonstrated by a quick scenario.
Assume a person has $100 to spend, and inflation is at a consistent 2%. The person can currently purchase $100 worth of goods/services. In a year, however, the goods will cost $102 due to inflation — and the $100 won’t cover the full cost of the same thing.
It’s thus better to have money now when goods/services cost less. In this scenario, it’s $2 better.
Alternatively, assume a person has $100 that they want to invest. They’ve come across an investment that offers a guaranteed return of 3% annually. If they have the $100 and invest it now, then the money will be worth $103 next year.
If they delay investment or don’t have the money for a year, they’ll only have $100 next year. The lost opportunity cost is $3.
Formula for Net Present Value
The formula for calculating NPV is more complex than many real estate formulas used. In order to calculate NPV, you need to know the following:
- Discount Rate: The target yield, or required rate of return. Often 3-12% for real estate investors, but can vary. This is what represents the time value of money.
- Initial Investment: The amount that an investor initially puts into a property. This would be the sale price of an all-cash purchase. More commonly, it’s the downpayment and ancillary costs of a mortgage that’s used to purchase a property. The mortgage balance isn’t an initial cost to the investor.
- Future Cash Flows: The projected cash flow, after all income, expenses, taxes and debt servicing have been taken into account for the duration of the holding period.
- Time: The holding period of a property, typically in years when evaluating commercial real estate.
The formula is as follows:
NPV = (CF1 / (1 + r)^1) + (CF2 / (1 + r)^2) + … + (CFn / (1 + r)^n) – Initial Investment
- CF = Cash Flow
- r = Discount Rate
- n = Number of Periods
Because this is an extensive formula, NPV is easiest to calculate using an NPV calculator. You can input the variables into an online NPV calculator.
How to Calculate NPV for Commercial Real Estate
Completing this formula requires estimating all of the cash flows associated with the investment, including rental income, operating expenses, taxes, and the eventual sale of the property. This estimation is usually the hardest part of the calculation, as it’s the most uncertain.
To use this formula and calculate the net present value, follow these steps:
- Expected Cash Flows: Estimate all cash flows of a property that best that you’re able to. Project rental payments, as well as any cash inflows from parking, storage, vending machines, tax benefits, or other sources. Project cash outflows for maintenance, operations, property taxes, and such. Use these to tabulate the expected cash flows.
- Discount Rate: Use your desired yield as the discount rate. An appropriate yield can be derived from personal target yields, and by comparing them to other investment opportunities.
- Calculate NPV: Input the cash flows and yield into an NPV calculator. You’ll also need the initial investment cost and your projected holding period. (You can manually calculate NPV using basic calculus, but even for math nerds an online calculator is easier.)
As an example, assume a property can be purchased for $1 million. The desired yield, or discount rate, is 5%. The holding period is 5 years. In this example, NPV would be as follows:
- If the property generated an annual positive cash flow of $200,000, it’d have a negative expected NPV of -$134,104,67. Although the property returns the initial investment of $1 million after 5 years, it fails to return the desired yield in addition to that investment. NPV is thus negative.
- If the same property has a positive cash flow of $250,000 each year, it’d have a positive expected NPV of $82,369.17. The property returned not only the initial investment but also the desired yield and then some.
Advantages and Disadvantages of Using NPV
As with any valuation method, NPV has both advantages and disadvantages.
Advantages of NPV
- Takes into account the time value of money, which some other valuation methods miss
- Allows for the accurate comparison of different cash flows and investment amounts
- Helps investors evaluate properties in light of their own target yields
Disadvantages of NPV
- Projecting future cash flows is inherently uncertain to a degree
- Using the formula with uneven cash flows is extremely cumbersome
Net Present Value vs. Internal Rate of Return
Net present value calculates the present value of future cash flows, while internal rate of return (IRR) measures the percentage rate at which an investment generates returns. The two are often used in conjunction with one another, NPV providing a dollar amount and IRR providing a percentage.
Wrapping Things Up
There are many ways to value investment properties, but it’s especially important when personally evaluating potential properties. Use NPV to make sure you have an accurate understanding of a property’s value in light of your own desired yield.