Using Net Present Value (NPV) to Evaluate Real Estate Endeavors

Jul 22

Written by: THE CABOT GROUP
7/22/2013 8:09 AM  RssIcon

Submitted by S. Laraby
Identifying the best real estate investments is no easy task.  There are a myriad of different measures to reach an often hypothetical valuation.  Net Present Value (NPV) offers investors the best option to measure the present value of future cash flows of a project, while taking the discount rate into consideration.  In real estate, the opportunity cost, or the next best investment alternative is often used.    

Net Present Value Formula: The sum of the cash inflow/outflow discounted back to its present value.  Embark on projects with NPV>0, reject those with NPV<0.

 where Rt = net cash flows, i = discount rate and t = time

A Simple Example:  Steve has identified a potential real estate investment.  The asset will cost $1,000,000 and will require initial remodeling costs of $100,000 per year for the first three years.  The investment will generate $60,000 per year in revenue.  At the end of the project, he will be able to sell the asset for $1,700,000.  The discount rate is 8%.  Should the investor take on the project?  

At a simple glance, an investor could calculate

Inflow: $1,700,000+$60,000(10)= $2,300,000

Outflow: $1,000,000+$100,000(3)= $1,100,000

                Net:  +$1,200,000, Take the project

Using Net Present Value, the investor reaches a different result.  NPV<0, so Steve should reject the project.  Due to the relatively high discount rate in this case, the opportunity cost of alternative investments, makes this a project the investor will not want to take on.  He is losing money relative to what he could have made elsewhere. 

 

Year 0: (-1,000,000 -100,000+60,000)/(1+.08)^0

-1,040,000

Year 1: (-100,000+60,000)/(1+.08)^1

-37,037

Year 2: (-100,000+60,000)/(1+.08)^2

-34,293

Year 3: (60,000)/(1+.08)^3

47,630

Year 4: (60,000)/(1+.08)^4

44,102

Year 5: (60,000)/(1+.08)^5

40,835

Year 6: (60,000)/(1+.08)^6

37,810

Year 7: (60,000)/(1+.08)^7

35,009

Year 8: (60,000)/(1+.08)^8

32,416

Year 9: (60,000)/(1+.08)^9

30,015

Year 10: (60,000+1,700,000)/(1+.08)^10

815,221

-28,292

 

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