Net present value is one of the most valuable tools that a buy and hold investor can use.
Before you make any financial decision, it’s important to determine whether it’s going to be worth your while. Although nobody can be absolutely clairvoyant, there are methods that you can use to calculate the potential profits of a specific investment. Investors and analysts have found many ways to calculate risk and reward, and one of them is by finding an asset’s Net Present Value (NPV).
What is NPV, how do you calculate it, and how can you use it to your advantage in real estate Investments? Marketplace Homes breaks down the basics of NPV so that you can make the most educated decisions about your acquisitions.
What’s NPV?
NPV is the number you come up with after subtracting the value of future cash flow from the present value of cash, including the initial investment. It essentially applies today’s dollar value to your future income stream from an investment. This value determines whether today’s investment will essentially hold up after withstanding potential risks, inflation, interest rates, and other costs.
NPV examines whether your anticipated gains will exceed today’s dollar value of your investment. It’s the closest we can get to a crystal ball regarding the value of your investment. If your NPV is positive, then your asset will likely earn you money. If it’s negative, then it’s not likely to earn you money.
A Dollar Today Isn’t The Same Tomorrow
The core theory behind NPV is that $1 today is not worth the same in the future. Factors like inflation come into play when considering how much the dollar will be worth in subsequent years. Profits must exceed the initial cost and value of the asset while considering that the future dollar won’t be as strong.
What’s a Good NPV?
When it comes to NPV, the higher the number, the better. Anything positive means you’re making money since the money made over time exceeds the initial startup cost. However, it is better to get a large profit v.s a minimal amount. A negative NPV means your investment is likely unprofitable because it won’t make enough money to exceed the initial investment.
How to Calculate Net Present Value in Real Estate
There are different formulas to calculate NPV based on different holding periods. Overall, it’s easier to get a more accurate figure when the term is shorter. However, the essence of all the formulas is:
- NPV= Expected cash flows based on today’s cash value − Today’s value of invested cash.
To estimate the value of today’s cash in the future, you factor in a discount rate. The higher the risk, the higher the rate. To determine the best discount rate for you, it’s best to speak with a real estate analyst.
Example of Finding the Net Present Value in Real Estate Investments
Ok, now that investments 101 is complete, let’s dive into a real-world example of how to apply this to real estate investment. Bob sees a single-family home that he wants to buy and hold. It will cost $200,000 and need around $20,000 in repairs. The monthly rent is projected to generate around $2,000 per month or $24,000 per year. Hey pays cash and doesn’t have a mortgage.
Bob plans to hold this rental for five years, and then he wishes to sell it for $300,000. His analyst gave him a discount rate of 7%. Without considering net present value, a novice investor would simply deduct cash out from cash in:
- Cash in: $300,000 future sale + ($24,000*5) monthly rent for five years = $420,000
- Cash out: $200,000 purchase price + $20,000 repairs = $220,000
Net: +$200,000
However, figuring in the discount rate gives Bob a more realistic picture of what to expect. After all, we can’t live in fantasy land and think that inflation, depreciation, or any other risk won’t happen to his single-family rental. Bob can then plug his yearly numbers into this convenient NPV calculator to factor in risks like inflation.
By year 5, the net present value comes to -$201,595.26. Based on these predictions, the investment is can make Bob *some* money if he plans to sell in 5 years, but with under 100k in rental profits, is it worth it to sell yet?
But what if he plans to hold the investment for 20 years and gradually increase the rent? With the same discount rate applied while gradually increasing the rent to $2,400 per month, the single-family rental will have earned him over $280k in rental profits in 20 years.
Do you need to find the right hold time and rental price for a potential investment? Using the NPV online calculator is a great start. Also, keep in mind that the average discount rates are between 7.5% and 9.5%, so it’s better to play it safe and not use a rock-bottom discount rate to anticipate a rental’s value.
Overall, the less you invest and pay to maintain a property, the more freedom you have regarding rental prices and holding times. When you figure in a mortgage, your cash flow will be a lot less compared to buying all cash, but you can still create a strong portfolio over time! To find out more about identifying profitable investment opportunities in our 30+ active markets, speak to a real estate professional at marketplace homes today.
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Alicia Persson is the real estate content writer for Marketplace Homes. She has several years of experience working in real estate teams that specialized in investments and property management. Before she joined MH, she was a freelance writer for 7 years, providing real estate and home living content for boutique digital marketing agencies.
She is a proud University of Virginia master’s graduate and enjoyed her undergraduate years at the University of Mary Washington. When she is not writing, she plays keytar and does female lead vocals in a local 90’s band or spends time with her amazing family.