Using NPV for real estate investments

[Account Closed]

I like to use Net Present Value when evaluating deals, but I don't see it a lot on this forum or other real estate evaluations. Can anyone shed some light on why not to use it?

[Dion DePaoli]

NPV works just fine as one of many evaluations of a deal. I use it every day at work (in the RE biz). NPV properly defined is the present value of future cash flows.

In the event you use IRR (Internal Rate of Return), you are already using NPV. IRR defined as the net present value of all cash flows from a particular project equal to zero.

Most don't use it simply because they don't understand it, frankly. I believe it to be a good tool. I also believe you can not avoid it, whether you want to admit it or not. To access your deal for a return, is to have NPV functionality under the hood.

In the example given, the NPV of the $1,000 annual cash flow is ($13,189) with a 12% hurdle. The cost of the investment ($20,000) is Period 0. Period 1 is $1,000, you don't net them in period 1.

P(0) - ($20,000)
P(1) - $1,000
....
P(15) - $1,000

Hurdle Rate = 12.0%

NPV = ($13,189.14)

So, what did NPV just tell us? Well it said, this deal, where we buy for $20k and get $1k per year for 15 years will not allow us to realize a 12% IRR potential as it is structured. It is not hard to figure that out, since we have $15k incoming over 15 periods and we spent $20k for the project. We are $5k short between incoming cash and outgoing cash to break even over the life of the project. We are fundamentally $13k short in cash flow to hit our 12% return target.

That shortage does not simply get plugged in and you are fine, since where the cash flow is realized matters in time and increment. So, the output of the formula has an abstract concept in that regard. Note my statement again, the NPV tells us, the investment as it is currently structured (cash in and out) does not achieve a 12% Return. It can be re-structured in many different ways. Longer hold period, say 25 years. We can input a gain on sale at some point in the future, where we liquidate the property.

The NPV of the per month cash flow which is $83.33 per month. At 12% hurdle, that cash is worth $937.92 at the end of the year.

P(1) - $83.33
...
P(12) - $83.3

Hurdle Rate = 12%

NPV = $937.92

NPV is pretty versatile and in the hands of a good user is pretty valuable. I don't believe it is something that loses it's utility if the deal get smaller or larger. I don't follow or agree with that logic.

As with any math equation, garbage in garbage out. However, I don't have to make assumptions on future value if I don't want and NPV allows me to evaluate the project still. For instance, the NPV for the 15 year cash flow is $6,810.86 at 12%.

So we have used NPV to calculate per period cash flow of year 1 and its value in relation to my 12% return target. We used NPV to calculate the overall project, where we did not make any assumption of the exit value in relation to my 12% return target. Was that valuable? Well, I guess if we wanted to know that information. Say we wanted to compare the discounted rental income for year 1 between two properties. We know the current cash flow structure to this project is not going allow us to realize a 12% return.

I think math in general screws with folks. Most laymen are simply use to simple math and treat investing more like household budgeting. It works but there are easier ways. NPV is not a budget concept, it is a discount and return concept. I also think the laymen set up their cash flows wrong, mixing net and gross all over the place. So it's output is a little abstract, its input is pretty finicky. So it is not first choice in use.

Does NPV tell us to do or not to do something? No, that is silly. Does addition tell you to cross the street? NPV is a valuable formula, if you use IRR, you are still using NPV under the hood and vice versa. To say one is good and the other is not ignores the math operations. It also seems to ignore we all run around with a targeted return number in our heads.