What is NPV?
When I was starting to learn about real estate and how to invest in real estate, I assumed that you needed some fancy software that would analyze the property to determine if it would be a good investment.
I still remember searching online for real estate analysis software, and the results were of programs that costs hundreds if not thousands of dollars.
There was obviously no way I’d spend that kind of money on a program when most likely the results wouldn’t make sense to me anyways.
I mean, all those fancy ratios, IRR, discounted cash flows, debt to equity, NPV, debt coverage ratio.
Sure, I could figure out how to calculate them, but what did it all mean.
Well, luckily, I didn’t spend thousands buying a fancy software program to help me analyze real estate, but I did learn some basics, and that’s all you need.
However, if there was one advanced ratio I’d recommend, to add to your arsenal, and help you become a better real estate investor, it would be knowing how to calculate a real estate investments net present value, or NPV.
And in today’s video, if you watch until the end, you’re going to learn what it is, and how it works, so, click below to watch it now.
If you know me, I’m a big proponent of using only a few financial calculations, such as cash on cash return, return on investment (ROI), payback period, and cap rate.
However, knowing how to determine the NPV for a property you are going to purchase, or a renovation project you are going to be doing, will be very helpful in your analysis and help you determine if the return you are looking for based on the cost of capital, the cost of the money you will be using, is good enough.
First though, what is net present value?
Well, the boring term according to Investopedia, it is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.
In laymen’s terms, what NPV does is it looks at the return you will make from your investment over a certain time period by calculating that return in present day dollars, because money in the present is worth more than the same amount in the future due to inflation.
In other words, a dollar earned in the future won't be worth as much as one earned in the present.
For real estate, this is a great calculation to use because a lot of times; and this correlates to the other financial calculations I recommend, which if you want to learn more about them, watch this video right here, it helps you compare to other investments you might be thinking of making with your money, with your capital, to confirm they will be a better investment.
By analyzing a potential investment properties NPV, you are determining if the return you are going to make based on the investment you will be making in the property, or in the project, is better than investing your money, your capital, in something else.
The great thing about calculating the NPV, is it takes into consideration the value of the debt and/or equity, or both, that you are using, weighting them based on how much you are using of each.
This is called weighting the cost of capital, because most of us when investing in real estate, will use our own money, our equity, and also the banks money, debt, such as a line of credit.
Quick side note, calculating the NPV of an investment is used more for long-term analysis.
It wouldn’t make sense to use this calculation if you will be buying a property to fix and flip, since those don’t take that long, and the whole point of calculating the NPV is to determine the future cash flow you will be making from the investment, discounting those future cash flows as a result of inflation and the opportunity cost of tying up your capital versus investing it in something else.
Ok, so to confirm, NPV is a great calculation to use when buying real estate to hold long term, as well as for a project, such as a renovation project to say update a property.
In fact, I had to analyze an upcoming project at one of my commercial properties recently, to figure out if it was worth spending $50K to renovate a unit, based on the inflows and outflows from the tenant whom wanted to lease the unit over the next 10 years.
So, I know firsthand that knowing the projects NPV can and was very helpful in determining if I should do the renovation, and if I did, at what inflows, that is, rental income, would I need to get, so that the net present value (NPV) of the discounted cash flows over those 10 years, minus the investment I’d be making, was greater than 0, based on the return that I wanted on the capital I would be investing.
So, is using this calculation easy to understand?
Well, not really, but it is easy to understand with practice.
The keys to determining the NPV are obtaining and figuring out all the necessary information you need such as calculating the project WACC, the weighted average cost of capital, and the projects beta, which is the risk involved in the project, along with knowing the cost of debt, the interest, if you will be borrowing, and your discount rate, which is the return you want on your money, on your equity that you’d be putting into the project, and how to bring it all together to determine if the projects rate of return from discounted the future cash flows meets the return you are looking to get from your investment.
It is a lot, and there are some advanced calculations that need to be done, so that you can calculate an investments NPV.
If you want learn more in depth about how to determine an investments NPV, click here to join my Facebook group, as I’ve uploaded an entire training where I walk you through how I calculated the NPV on my most recent commercial project, to determine if it was worth investing $50K to update the unit, or not, based on the return I was looking for on my money, my equity, which was 10%, and the debt I had to borrow, which cost me 4%. WHAT DO DO NEXT: Join my Facebook Group to Learn How I Calculate NPV