Net present value is the difference between cash inflow and outflow for an investment over a period of time. By calculating the present value of both cash in and cash out in investment planning, NPV can analyze the profitability of a proposed investment by taking into account inflation. With an NPV in mind, you can ensure that your commercial real estate investments will be profitable in the long term, not just when you first acquire them.
How Do You Calculate an NPV?
To calculate your investment’s NPV, you need an estimate of future cash flows as well as a determined discount rate. A discount rate is the interest rate of discounted cash flow. It represents how viable an investment is in terms of the time value of money. To select your discount rate, consider how much you are investing today and your desired rate of return as appropriate for the size and risk of the investment.
Once you’ve chosen your discount rate, take your investment’s initial cost and compare it to the investment’s future cash flows, both inflow and outflow. To think of NPV as a true calculation, consider this formula, where TVECF is today’s value of expected cash flows and TVIC is today’s value of invested cash with respect to future inflation:
NPV = TVECF – TVIC
If the difference between the initial cost and the future cash flow is a positive number, the investment is sound and can earn you more than you expect to pay. If the difference is a negative number, the expected net present value is a loss and the investment should be avoided. Remember that this positive relies on the discount rate, which can be adjusted according to your investment interests.
NPV and Commercial Real Estate
When it comes to commercial real estate, NPV acts as a metric to decide between potential investment properties. By accounting for the time value of money, it can predict how viable an investment can be to the investor now and in the future. Using the same principles of cash flows and invested cash, NPV takes a building’s current cash flow in, cash flow out and your required rate of return.
For commercial real estate, NPV can also show how much a particular building is worth in the current real estate market. A positive NPV not only means that the investor receives more cash inflow than they spent on the property, it also ensures that they are paying less for the property than it’s worth. If it’s a negative number, the investment is both a financial loss and a decision that can prevent you from putting money down on another investment opportunity.
NPV vs IRR
While NPV calculates whether or not a commercial building is worth investing in, the internal rate of return looks at the financial gain of each dollar invested. The main difference is in how the formulas operate in relation to the same financial considerations. While the ideal NPV is a positive number that ensures the investor is paying less than the property is worth, IRR is the number that shows the interest rate needed to ensure an NPV of zero.
NPV is a necessary consideration when approaching any financial investment. In the commercial real estate market, NPV is essential for understanding the standing worth of a building in relation to how much it will earn the investor over time. By calculating NPV, there is less of a chance of making an uninformed financial decision.