Before committing capital to a commercial real estate investment, one of the most important questions an investor may ask is, “if I make this investment, what is my potential return?” There are a number of metrics used to answer this question, one of which is known as the Net Present Value (NPV).
In this article, we are going to discuss what NPV is as it relates to real estate investing, why it is important, how it is calculated, and how it compares with another commonly used valuation metric, internal rate of return. By the end, investors will have the information needed to calculate NPV as part of their own pre-investment due diligence process.
At First National Realty Partners, we are a private equity firm who specializes in the purchase and management of grocery store anchored retail centers and, before committing to any transaction, we always use NPV to assess potential profitability. If you are an accredited investor, interested in partnering with a private equity firm to allocate capital to a commercial real estate investment, click here.
What is NPV in Commercial Real Estate
In a typical Commercial Real Estate (CRE) transaction, NPV (sometimes called discounted cash flow (DCF) analysis) is a valuation metric that helps real estate investors understand the profitability of a potential investment.
How to Calculate NPV
NPV is usually calculated as part of the pre-investment due diligence process and there are four inputs needed: the discount rate, the initial investment, future cash flows, and the time in the holding period.
The Discount Rate
An easy way to think about the discount rate is as the investor’s required rate of return or target yield, annually. It varies from one investor to another, but is usually somewhere in the 4% – 12% range depending on the property type, location, interest rate, and market conditions.
The Initial Investment
The initial investment represents the initial cash outflow when a property is purchased.
If paying cash for a property, the initial cash outflow is the same as the purchase price. For example, if a property has a cost of $1MM and an investor is paying cash to purchase it, the initial cash outflow is $1MM.
In a more common scenario, an investor is going to get a loan to finance most of the purchase. In this case, the initial investment is the difference between the purchase price and the loan amount. For example, if a property has a purchase price of $1MM and an investor gets a loan for $700,000, the initial investment is $300,000.
Future Cash Flows
In a commercial property, future cash flows may be the trickiest input. They are estimated by creating a proforma projection of a property’s income, expenses, debt service, and taxes for the duration of the planned holding period. Any money left over after all expenses have been paid represents a cash inflow for investors. For example, if a property has $100,000 in annual income and $80,000 in expenses (including dent service and taxes), the remaining $20,000 is an inflow for investors.
Finally, time is the number of periods (usually years) in an investor’s planned holding period for the property. Once an investment is made, the time period can change based on market conditions, but this input is designed to reflect the initial planned holding period. For most commercial properties, the planned holding period is usually in the five to ten year range.
Once these components are known, NPV is calculated as the sum of future cash flows, for each investment period, discounted back to the present with the chosen discount rate.
When calculated manually, the NPV Formula can be complex, but the NPV calculation is rarely calculated in this manner. Instead, cash flows are typically forecast in a spreadsheet program (Excel or Google Sheets) and the “NPV Function” handles the calculation automatically for a given set of net cash flows and a discount rate.
NPV – An Example
To illustrate how NPV works, an example is helpful.
Suppose ABC Corporation is considering purchasing a 50-unit apartment building as an investment property. It has a purchase price of $5,000,000 which will be paid in cash at the time of sale and the proforma estimates future cash flows of $1,200,000 per year over a five year period and a discount rate is 5%. The following table displays this scenario:
At a discount rate of 5%, the NPV of this series of cash flows is $195,372. But, what does this actually mean?
What Does NPV Mean and Why Is It Important?
When calculating NPV, there are three potential outcomes:
- Positive Number: If the outcome of the calculation is a positive number (“positive NPV”), it means the planned purchase price is less than the present value of the cash flows, at the chosen discount rate. This is the preferred scenario, the bigger the positive number the better, and it suggests a potential profit.
- Zero: If the result of the NPV calculation is zero, it means the investor is paying exactly what the series of cash flows is worth for a given discount rate and time period. It also means the discount rate is equal to the internal rate of return (IRR). Zero is not necessarily a bad thing, it means the investor is paying a fair price for the property.
- Negative Number: If the result of the NPV calculation is a negative number (“negative NPV”), it means the investor is overpaying for a series of cash flows, at the chosen discount rate. There may be scenarios where this makes sense, but it should generally be an indication that investors should re-evaluate the discount rate and/or the purchase price.
Understanding the Time Value of Money
The utility of the NPV calculation hinges on a concept known as the “time value of money” and it is critical to understand when evaluating commercial real estate investments.
Time value of money holds that money is more valuable today than it is tomorrow, largely its ability to be reinvested over time and earn interest. To illustrate this point, consider a simple question. Do you think an investor would prefer to be given $1,000 today or $1,000 five years from now. The time value of money concept suggests the better deal is to take the $1,000 today and to reinvest it with the hope it will be worth more than $1,000 in five years.
So, this concept explains why future proforma cash flows are “discounted” back to the present period of time to determine the appropriate value.
NPV vs IRR
NPV is often used in conjunction with another profitability metric, the internal rate or return or IRR.
Internal Rate of Return is used to measure the return on a future investment, for each period of time it is invested in. Like NPV, it requires the completion of a proforma and the estimation of a series of future cash flows. Also like NPV, it has a complex calculation formula, but is easily calculated using the “IRR” function in a spreadsheet program.
While the result of the NPV calculation is a dollar figure, the result of the IRR calculation is a percentage indicative of the annual return with a given set of cash flows. Again, when the NPV is equal to zero, it means the discount rate is equal to the IRR.
Summary of NPV in Commercial Real Estate
The Net Present Value is one of the most important commercial real estate metrics for investors to understand and it measures the potential profitability in a transaction.
To calculate NPV, there are four inputs needed, the purchase price, the discount rate, the annual cash flows, and the holding period of the proposed investment. When calculated manually, the net present value formula can be complex, however it is rarely done this way. Instead, the “NPV” function is used in a spreadsheet program.
There are three potential outcomes to the NPV calculation – positive number, negative number or zero – and they provide insight into the potential profitability of the deal..
NPV is rooted in a concept known as the time value of money, which holds that $1 earned today is more valuable than $1 earned in the future due to its ability to be reinvested and earn interest. This is why a property’s future cash flows are estimated and then “discounted” back to the present value to determine if the purchase price has room for profit.
Finally, NPV is often used in conjunction with IRR, which is another profitability metric that measures the return on each dollar invested, for each period of time it is invested in. NPV produces a dollar amount and IRR produces a percentage. If the NPV is equal to $0, it means the chosen discount rate is equal to IRR.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.