Using Net Present Value (NPV) to Evaluate Real Estate Endeavors
Submitted by S. Laraby
Identifying the best real estate investments is no easy task. There are a myriad of different measures to reach an often hypothetical valuation. Net Present Value (NPV) offers investors the best option to measure the present value of future cash flows of a project, while taking the discount rate into consideration. In real estate, the opportunity cost, or the next best investment alternative is often used.
Net Present Value Formula: The sum of the cash inflow/outflow discounted back to its present value. Embark on projects with NPV>0, reject those with NPV<0.
where Rt = net cash flows, i = discount rate and t = time
A Simple Example: Steve has identified a potential real estate investment. The asset will cost $1,000,000 and will require initial remodeling costs of $100,000 per year for the first three years. The investment will generate $60,000 per year in revenue. At the end of the project, he will be able to sell the asset for $1,700,000. The discount rate is 8%. Should the investor take on the project?
At a simple glance, an investor could calculate
Inflow: $1,700,000+$60,000(10)= $2,300,000
Outflow: $1,000,000+$100,000(3)= $1,100,000
Net: +$1,200,000, Take the project
Using Net Present Value, the investor reaches a different result. NPV<0, so Steve should reject the project. Due to the relatively high discount rate in this case, the opportunity cost of alternative investments, makes this a project the investor will not want to take on. He is losing money relative to what he could have made elsewhere.
|Year 0: (-1,000,000 -100,000+60,000)/(1+.08)^0||-1,040,000|
|Year 1: (-100,000+60,000)/(1+.08)^1||-37,037|
|Year 2: (-100,000+60,000)/(1+.08)^2||-34,293|
|Year 3: (60,000)/(1+.08)^3||47,630|
|Year 4: (60,000)/(1+.08)^4||44,102|
|Year 5: (60,000)/(1+.08)^5||40,835|
|Year 6: (60,000)/(1+.08)^6||37,810|
|Year 7: (60,000)/(1+.08)^7||35,009|
|Year 8: (60,000)/(1+.08)^8||32,416|
|Year 9: (60,000)/(1+.08)^9||30,015|
|Year 10: (60,000+1,700,000)/(1+.08)^10||815,221|