Net Present Value (NPV) - the most accurate deal analysis?
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Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes
15yNo need to buy the book. I bought it and found it largely a waste of time. Here's what I would read:
Buffett's letters to his shareholders, which are available for free at BRK's site. http://www.berkshirehathaway.com/letters/letters.html
Buffett's letters when he ran a hedge fund that he referred to as the Buffett Partnership. I believe you can get those by googling or at this site: http://www.ticonline.com/buffett.partner.letters.html
Buffett's letters to shareholders are better from the perspective of understanding the bigger picture. The letters to partners are more useful if you wish to be a stock investor. They are both enjoyable to read because he has a very nice writing style with plenty of aphorisms, wit and humor.
31 Replies
- 16yDon KonipolBusiness MemberInvestor · The Woodlands TX / Avon, CT · Member since 2009 · 6k+ posts · 10k+ votes
NPV is defintely the best measurement of value for any investment. However, it's advantage over the simpler methodolgy of ROI decreases as inflation is lowered. When inflation kicks in once again the penalty paid for using ROI instead of NPV will increase.
- Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes16y
The trouble with NPV for small real estate investing is that one's cost of capital is a lot harder to define for any given project. I much prefer IRR or MIRR given this uncertainly despite its minor drawbacks.
- 16yJohn K.Real Estate Investor · Topeka, KS · Member since 2010 · 63 posts · 40 votesOP
I am not sure how do you mean the influence of the inflation in the NPV calculation.
I am using this formula:
... where the i is a discount rate, t is the year and CFt Cash flow in that year.In my opinion the influence of inflation isn't included in the NPV formula, but let me know.
- Lexington, KY · Member since 2010 · 315 posts · 133 votes16y
I think Don was saying he plugs inflation for the discount rate?
Choosing a discount rate, and as Bryan indicated - knowing your exact cost of capital per project is the difficult part.
IRR is probably the best means of investment analysis IMO. Similar in some ways and incorporates time value of money, but gives you an exact number for the "return" of the project. You can compare these returns. But, as you will realize, the deeper you delve into getting the "best" and the "most exact" investment analysis you realzie that there truly are so many variables that can't be quantified or plugged in.
10% IRR vs. 11% IRR - well it's a no-brainer then, right? Well not exactly because you can't quantify potential costs you overlooked, area the house is in, condititon of the market, or even what buyers might just happen to show up at your open house and make an offer a year from now. Point being, investing is not an exact science, although the use of IRR is smart in terms of investment analysis and is one of the most precise analyses, at the end of the day you must fall back on your "gut" and intuition. Your brain can use such analysis (IRR) and also take into account other qualitative aspects of a deal that no model will ever comprehend.That is why many investors use good rule of thumb metrics, like 50% rule, for initial screening. Calculate a more precise cash flow, or IRR if you wish, and then make the decision intuitively.
- Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes16y
In my opinion, NPV in and of itself isn't enough of a financial measure to determine whether a particular project is worth undertaking...
First, it doesn't factor risk into the equation (and no, you can't just increase the discount rate to account for risk, it's not a linear relationship). Second, NPV doesn't provide enough information to allow two projects to be compared head-to-head without addition financial measures.
Now, if you combine NPV analysis with both IRR analysis a detailed risk assessment, I believe that will result in a reasonable overall assessment of a project or a set of projects.
Just fyi, I wrote a blog post here last week on IRR that touches on the importance of that measure:
http://www.biggerpockets.com/renewsblog/2010/09/02/introduction-to-internal-rate-of-return-irr/
- Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes16y
Jimmy’s post rocks! In fact, one of my first BP blogs for Josh explores a lot of this in detail. I wrote the article yesterday and it should go out in the next week or so.
Regarding inflation, the expectations will be baked into whatever cost of capital you choose to do your discounting. Banks price these same expectations into their pricing for their capital too, in theory. So the inflation variable may not be present in the “formula†you gave above, but the compensation for risk associated with inflation expectations is present in the formula.
Cash flows past year 5 are meaningless in ANY investment analysis IMO. The first 2-3 observations should be sufficient to figure out whether or not the investment is worth pursuing. I guess the subsequent cash flows would have more meaning for highly stable organizations signing leases and thus providing ultra stability to the investment. Given the nature of most of the real estate deals I see the analysis hinges much more on qualitative factors and common sense than it does on fancy modeling.
- 16yJohn K.Real Estate Investor · Topeka, KS · Member since 2010 · 63 posts · 40 votesOP
I agree that the determining the discount rate (cost of capital) can be pretty difficult in real estate. When I do the NPV analysis, I use discount rate as a rate I could probably earn on similar risky investment (ie. on financial markets). Even though it is not that exact, using CAPM (Capital Asset Pricing Model) as a discount rate didn't work much for real estate.
How are you guys determining the discount rate in your calculations?
In my opinion, if I keep my method of determining the discount rate consistent, I can still compare various properties (investments).
I also agree that NPV can't be the only measurement of an investment. The same thing is valid for IRR, though.
IRR doesn't take in account much the size of the initial investment needed. If there would be two investments, generating both 10% IRR, one can have initial investment of $10K and one $100K and you can't tell just from looking at IRR.
For this reason also Profitability Index is a good calculation, in my opinion.
Profitability index = (Present Value of Future cash flows) / Initial investmentAnyway, you are right as well that calculations is one thing, but then you have to access the investment with common sense and guts to make the final decision. However lot of "investors" are using just the guts and no calculations, which is bad as well.
- Lexington, KY · Member since 2010 · 315 posts · 133 votes16y
Originally posted by John K:
IRR doesn't take in account much the size of the initial investment needed. If there would be two investments, generating both 10% IRR, one can have initial investment of $10K and one $100K and you can't tell just from looking at IRR.
Perhaps this is where you could use cash on cash return as well. You should know what you'll have to put into a project, and that is why people use detailed cash flow metrics because it is the cash flow that really matters. Even in business cash flow is the most important. Check out J Scott's profile and you can download a good cash flow spreadsheet he has uploaded for the use of BP memebrs.
The trick is to use many metrics and to understand exactly what the metrics mean. I like cash flow IRR and 50% rule for screening.
- Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes16y
CAPM in my opinion doesn’t work well for any investment analysis. I am sure others will disagree, but forecasting more than 2-3 variables for the economy and thus systemic risk is impossible. All assets were pretty correlated recently with the whole system melting down. Fancy models keep legions of MBA grads employed, but I never have put a lot of stock into their analysis. Their crystal balls are perhaps marginally better than mine, but not accurate enough to make money in MOST instances.
IRR or a consistent NPV analysis are each fine. Investing has more to do with instincts and experience in assets classes than sophisticated modeling IMO.
Many “investors†are really just glorified employees in my opinion. Others on here share that opinion from the posts I have read. If you are constantly hustling to make money to “fire your boss†you are still an employee and not an investor.
Guts are a big part of real estate investing because of the uncertainty involved in any project. Turnaround projects are especially risky and entrepreneurial and thus the projects require even more guts. These are the projects with the most upside and where the models work the least well. Stabilized product with great credit tenants is where these models apply well. That isn’t the world most of the people on this board play in and thus the modeling is less useful although I agree that seat-of-the-pants analysis is bad too.
- 16yJohn K.Real Estate Investor · Topeka, KS · Member since 2010 · 63 posts · 40 votesOP
Thanks for the answers everybody! It is really interesting to hear the opinions.
Anyway, even though it seems that most of you prefer IRR, if you are using NPV, what do you usually use as a discount rate? What do you think is the best way to determine it?
- Landlord · Seattle, WA · Member since 2010 · 3k+ posts · 1k+ votes16y
I used both NPV and IRR, but I have found that it is more important to have a good modal of cash flows to have meaningful inputs. Many investors fail to consider all of the costs of an investment which skews any analysis.
If you are fine tuning your investment decisions it is necessary to have good inputs.
- Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes16y
Originally posted by John K:
Anyway, even though it seems that most of you prefer IRR, if you are using NPV, what do you usually use as a discount rate? What do you think is the best way to determine it?I let this stew for a bit to see if anyone was going to provide a good answer. I don’t think there is generally a good answer to this question when distress is involved because each project is very different than the one that comes before it. Consequently, the risk associated with each project is difficult to quantify rigorously. The only good way is to pick values based on seat-of-the-pants guesses that distort the analysis every bit as much as modeling cash flows past year 5 or so.
For stabilized projects a WACC begins to have more meaning. The WACC can be broken into two components:
1. The required return on equity
2. The debt constantThe weighting depends on the project and item 2 above is generally 70-80% of the WACC using normal leverage assumptions. The debt constant annually is the sum of all mortgage payments – both principal and interest – divided by the mortgage balance. Fully-amortizing loans thus have a debt constant HIGHER than the interest rate for the loan. The delta is used to pay off the loan. Interest-only loans don’t amortize so the debt constant should be the same as the interest rate. So your WACC will depend on the type of loan, the interest rate, and the amortization period if applicable.
Equity and debt are weighted according to the project’s capitalization and voila, you have a discount factor for your NPV calculation. Note that you can adjust this WACC if you feel that your equity returns need to be adjusted north for distant cash flows due to uncertainty in forecasting them.
- Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes16y
Originally posted by John K:
Anyway, even though it seems that most of you prefer IRR, if you are using NPV, what do you usually use as a discount rate? What do you think is the best way to determine it?
I don't generally use NPV for any real estate evaluation, but I did work for a very well-known tech company that used NPV analysis for pretty much *EVERYTHING*. From major projects to adding a new button to a web-page.
In my experience, larger companies are more constrained by their workforce than they are by their budgets, so the discount rates in these situations will often be the opportunity cost of not being able to do other projects because of lack of staff.Now, for smaller companies (and individual investors), the more common scenario is that the investor is borrowing money and has to decide whether the investment is fruitful given the cost of capital. In these cases, the discount rate would be the cost of capital (i.e., the interest rate on the loan).
Just my experience...not sure how others do it or how most real estate investors do it (though I imagine very few investors are diligent enough to ever even think about it).
- Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes15y
This is a great topic worth bumping....
- Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes15y
Consider it bumped Brian!
The NPP and discounted IRRs are fine for financial analysis when income strems can acurately be estimated, say in a bond analysis, but RE has too many variables that will come into play to make such analysis irrelevant. While it may be fun to punch numbers (I use to play with it, as a finance type I admit it) doing so and giving weight to such activites in making a buy decession is a mistake. A tornado comes along 6 months later, you throw in $1,000 for the deductable and lose 20% rental income, you're analysis is skewed. The income from RE is not reliable enough to give much stock to analysis.
About the only thing that makes sence is historical computations, looking to where you have been with known data. Such might be useful for marketing your expertise, but not much beyound that.
- 15yJohn K.Real Estate Investor · Topeka, KS · Member since 2010 · 63 posts · 40 votesOP
Originally posted by Financexaminer:
Consider it bumped Brian!The NPP and discounted IRRs are fine for financial analysis when income strems can acurately be estimated, say in a bond analysis, but RE has too many variables that will come into play to make such analysis irrelevant. While it may be fun to punch numbers (I use to play with it, as a finance type I admit it) doing so and giving weight to such activites in making a buy decession is a mistake. A tornado comes along 6 months later, you throw in $1,000 for the deductable and lose 20% rental income, you're analysis is skewed. The income from RE is not reliable enough to give much stock to analysis.
Hi,
I would disagree with Financexaminer - hope he doesn't mind. ;o)
In any calculations of investment returns (even the ones like cash on cash or ROI), you will be inaccurate, when something unexpected happens (like the tornado in your example). It doesn't matter if you are calculating IRR, NPV or Cash-on-cash. It will always skew any type of analysis.
When you would want to be really accurate, you could find out some statistics about the natural disasters in the area and include the risk and probability of that in the calculations.
Anyway, I really think that it is very advisable to calculate the methods which take in count the time value of money. You can make decisions, which might not be financially the best, when you use only the simple calculations.
I agree that for most of the people and smaller investors, it can be hard to figure out the discount rate for calculating NPV, and so after discussing it here - I will be using IRR much more in the next version of my real estate investment software.
- Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes15y
I agree with both of you ;-)...which is to say that both arguments have merits. Any analysis past 3-5 years is magic ball voodoo IMO, even if it is based on stable commercial leases. That is why investors have a liquidity preference and different discount rates should be used in the ideal world for shorter-term cash flows.
I don't subscribe to the idea that the analysis is worthless though. It just isn't the end-all-be-all that people think it is when they exit business school. Simple ratios and good investing instincts trump elaborate analysis and someone that is a novice investor. Having been there and done that to structure the deal properly is every bit as important as the numbers, but the numbers are not worthless.
- Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes15y
And I agree as well! The tornado is a rather exaggerated example, but it was to make a point, so condier something as small as simply miscalculation of maintenance, which prior to buying is an educated guess.
But, the NPV is inappropriate and for a small investor finding their opportunity costs to arrive at a cost of capital, I would say that if anyone accurately identified such figures after the facte they would be lucky....it's almost an impossibility as unforseen opportunities will never be known as opposed to other investments, like saying I could have invested in a bond. That's in keeping with that investor seeking like kind investments in real estate since risk is also a part of the equation.
I agree that the IRR is more appropriate and that the cash on cash evaluation is more significant.
The tornado example is something I would have used perhaps with a college finance class when I taught finance, not that it was the most realistic, but that any change in assumed data of your pro forma could greatly effet the outcome. But, you guys are beyond that, as you do get it! And you have come to the same conclusion! Seems everyone agrees!
- Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes15y
Yeah...I have been preaching that fancy models for small real estate investors are a waste of time for years now. Cost of capital is well-defined for large companies with access to liquid financial markets. Small businesses and real estate investors are subject to the whims of what used to be lenders....that are now glorified servicing agents for the gov-mint.
- 15yJohn K.Real Estate Investor · Topeka, KS · Member since 2010 · 63 posts · 40 votesOP
Originally posted by Bryan Hancock:
Yeah...I have been preaching that fancy models for small real estate investors are a waste of time for years now. Cost of capital is well-defined for large companies with access to liquid financial markets. Small businesses and real estate investors are subject to the whims of what used to be lenders....that are now glorified servicing agents for the gov-mint.Well, I know that I can't expect that everything will be going as I have estimated it in an analysis for the next 20 years, on the other hand, there are situations when you can be just guessing without a good real estate analysis.
For example - when I was searching an investment property, I had a few properties in pretty much same area, of a similar type and age. In that case, I will use the analysis (and I mean IRR or NPV) for comparing these properties - to choose the one which will be more profitable for me.
Another good example - I was just negotiating seller's financing for a while, and without the knowledge of NPV and IRR, I simply wouldn't know what to fight for in the negotiations. I was able to present a few different options, which has the same financial profit for me and when the seller wanted extra 1% on interest, I have seen what it will change, and how I should counter to keep the same NPV (IRR) - such as making the amortization longer, etc. Being able to calculate everything and compare (even it's partially estimation) I had a big advantage against the seller who was just guessing.
- Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes15y
Yeah....the tools measure things perfectly. The trouble is knowing what to put in the tools. Garbage in....garbage out.
At the end of the day it is pretty simple to hedge certain risks and it is pretty easy to spot something that is more risky than an alternative investment. The trick is trying to optimize your returns for the given level or risk you are willing to take...no easy task!
- Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes15y
I am surprised I missed this thread earlier. I know a little bit about this subject and here are some general guidelines:
1. NPV, as Bryan has mentioned, is for investors with a known cost of capital and a known ability to continue to raise funds at that cost. It is used to determine if a project is worth investing in or not. If the NPV is positive, you should invest and if it is not positive, you should not.
2. NPV is a lousy way for most of us to invest. We neither know our cost of capital nor do we have the ability to raise funds to meet all our investment opportunities.
3. Bryan's WACC is not going to solve the cost of capital problem although it appears to do so. This is because the "return required on your equity" is the very same unknown that we are referring to as cost of capital. If you know exactly what return you want on your equity, then it is easy enough to figure out the cost of capital using WACC. But the real life problem for us is that we have many investment opportunities and limited funds, which is pretty much the opposite problem of larger investors. Therefore, we need a simple method to compare different investments and the IRR does this quite well.
4. And, while I agree that there are uncertainties in life and with any investment portfolio, that is not an excuse to fail to analyze one's options. Instead, one should continue to employ an analytical approach while being cognizant of its limitations. It is also important not to try to be overprecise in one's analysis. As Buffett often says, it is better to be approximately right than precisely wrong.
- Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes15y
Originally posted by Vikram C.:
But the real life problem for us is that we have many investment opportunities and limited funds, which is pretty much the opposite problem of larger investors. Therefore, we need a simple method to compare different investments and the IRR does this quite well.^^^
Wisdom!I always despised those flippant little sections of finance texts that summarily discounted the value of IRR because it has more than one solution in some cases or isn't a perfectly elegant mathematical solution. Who the F cares? It works better than anything else for most real estate investment decisions! Throw out the trivial solutions Mr. Investor and use the correct IRR...pretty simple.
Originally posted by Vikram C.:
As Buffett often says, it is better to be approximately right than precisely wrong.
Yeah...that Buffett guy knows his stuff. I need to get off my rear and read those essays you have been imploring me to read. I read Ben Graham's book last year...much of it was boring, but there was definitely some great material in there.I think there is a book of Buffett essays...should pick that off as my next read.
- Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes15y
No need to buy the book. I bought it and found it largely a waste of time. Here's what I would read:
Buffett's letters to his shareholders, which are available for free at BRK's site. http://www.berkshirehathaway.com/letters/letters.html
Buffett's letters when he ran a hedge fund that he referred to as the Buffett Partnership. I believe you can get those by googling or at this site: http://www.ticonline.com/buffett.partner.letters.html
Buffett's letters to shareholders are better from the perspective of understanding the bigger picture. The letters to partners are more useful if you wish to be a stock investor. They are both enjoyable to read because he has a very nice writing style with plenty of aphorisms, wit and humor.
- Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes15y
Wow! Great find V....I'd like to vote for you, but I'm out of bullets!
What is Buffett's take on NPV and IRR Vikram?
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