What is Net Present Value?

In commercial real estate finance, the Net Present Value (NPV) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the Present Values of the individual cash flows of the same property.

NPV is a central tool in Discounted Cash Flow ("DCF") analysis and is a standard method for using the time value of money to analyze long-term projects. Used for capital budgeting and widely used throughout economics, finance, and accounting, NPV measures the excess or shortfall of cash flows, in present value terms, above the cost of funds.

The Net Present Value Formula

Each cash inflow/outflow is discounted back to its Present Value, then they are summed.

I = the period's net cash flow
r = the discount rate
n = the period of the net cash flow

Why is Net Present Value important to consider when investing in real estate?

n I r Result
Year 1 10,000 8% 9,259
Year 2 10,000 8% 8,573
Year 3 10,000 8% 7,938
Year 4 10,000 8% 7,350
Year 5 10,000 8% 6,806
Year 6 10,000 8% 6,302
Year 7 10,000 8% 5,835
Year 8 10,000 8% 5,403
Year 9 10,000 8% 5,002
Year 10 10,000 8% 4,632
Sale 100,000 8% 46,319
  200,000   113,420

By calculating the NPV of a set of cash flows, investors are able to carefully value any property.

Let's look at an example. Let's assume we're underwriting an investment property which is expected to generate $10,000 per year for the next 10 years. At the end of this 10-year period, we project we can sell the property for $100,000.

As an investor, for this type of investment, we target an 8.0% return on our investment. This targeted return is "r" or the "Discount Rate" within the NPV formula. By discounting these cash flows by 8.0%, we are able calculate the price we are willing to pay for the property.

In this instance the sum of the 10 years of cash flow from this property totals $200,000. The sum of the discounted the cash flows at a rate of 8.0% equals $113,420. This figure represents the price we should be willing to pay for this property, so that we are able to realize a return of 8.0%.

Our Net Present Value Calculator uses the steps outlined above to calculate the Net Present Value of investment property.

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