Using NPV for real estate investments
Accountant · Philadelphia, PA · Member since 2013 · 303 posts · 210 votes
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.
@Account Closed Net present value is a relatively sophisticated concept. So like Bryan says many don't know what it is or how to apply it.
However just as importantly it just doesn't apply to most deals. In most deals you know your price going it so a future value would be more of an Internal Rate of Return calculation. I am not sure how you would use NPV in most real estate deals. Can you give me an example?
I'm not entirely sure what you mean, either. "Present Value" is a simple calculation. If you have a stream of payments and you know the other four parameters (future value (often zero), payment amount, rate and number of payments) you can calculate the present value. That's simply the reverse of using PV, rate, term and a future value of zero to calculate the payment on a loan. OTOH if you're considering buying a note, you can use PV to calculate what you're willing to pay to give you a specific return.
Now, I've seen all sorts of speculate calculations put together on investment properties, and investments in general, that compute all sort of numbers that get given all sorts of names. In particular, I've seen analyses of rentals where there are all sorts of assumptions about future rent increases and appreciation that are used to dress up a crummy rental.
IMHO, if you're buying rentals you should understand the true cash flow you're going to get tomorrow. If you're looking for income right now, that better be a positive number. If you're willing to feed money into the deal in exchange for having a free and clear asset 15 or 30 years from now you should understand how much you have to feed in.
I like the idea of "scenario planning". That's where you use different sets of guesses about the future. E.G., what happens if rents, expenses and values all stay flat for 30 years? What if they all rise by 3% annually? What if they fall by 3% annually? These aren't predictions. They're what-if's. If the deal makes money with a broad set of scenarios, its probably a good deal. If only a few scenarios make money then you have much smaller prospects of a profit. Only if one of the few profitable scenarios actually happens do you make a profit.
@Jon Holdman I think were talking about the same thing with PV and NPV. My understanding is that NPV is Current Outflow - PV of Future Cash Flows. So if NPV is positive at the end of the calculation the investment is a win. I like the idea of running different scenarios and then weighting the outcomes (i.e. 25% things go really bad, 50% normal conditions, 25% things go really good) to see how the numbers run.
@Ned Carey Agreed it wouldn't factor into many short term deals, but it will help buy and hold investors get the return they desire instead of just taking anything that will cash flow year one. Instead of figuring an IRR you have your own IRR and you calculate if the deal is above or below the IRR.
When I think about the NPV here's a simplified example with #'s.
So the facts:
The first year my cash flow would be -$19k (20K downpayment and $1k net from rent). No Present Value factor would be used.
The second year my cash flow would be $1k. I would need to discount this PV based on the 12% I want to make. You can find PV of $1 tables on the internet and apply that to the cash flow. I see the PV of $1 after one year using a 12% IRR is .8926, so my $1 is only $829.
I keep doing this until the final year where I discount the cash flow from the house the same way I did year one except I use the 15 year factor.
If I add all of the cashflows from year 1-15 that have been discounted to present value dollars, I would get my NPV. If my NPV is positive, I'm making more than 12% and the project is a go.
This is just a simple example, but any finance gurus feel free to add or correct me.
NPV analysis will only tell you if an investment will produce a positive income stream over a fixed time and fixed discount rate -- it won't tell you about opportunity costs or whether the investment makes sense given a larger portfolio. In other words, it will tell you if you can expect to make money or not, but it won't tell you how much and if the effort is worth it.
While determining if an investment will yield a positive return is important, there are lots of less complicated ways to do that for a real estate investment, and the other ways will often help you evaluate the degree of profitability as well.
The only time I could imagine using NPV for real estate investments is if you have more money than you have potential investments, and you're willing to invest in any project that yields a positive stream of income or profit.
Sorry @Account Closed but I think you are using NPV incorrectly. NPV is used when you know the future value and you apply an interest rate to decide what it is worth to you today. You don't know the future value of the property. You are guessing. But you do know the value today.
I think your calculations are at best a complicated way to get the number you want. At worst it is probably giving you a junk number that is not very useful. It appears you are trying to discount a future value even though you are earning a return along the way. You are double counting your returns.
NPV has a few problems I can think of when it relates to real estate and trying to use it for smaller projects:
1. Most investors are horrible and figuring out how risky a project is and thus would do a terrible job of selecting a discount rate. Real estate isn't like a bond or an equity traded on a public market with millions of eyeballs establishing value. In many distressed scenarios there may only be one person selecting the value to assign to an asset
2. Investors are often capital-constrained and thus don't have access to more capital at a moment's notice. Thus this would distort the discount rate pricing as well
I often see folks use IRR as a selection tool instead. IRR has problems as well, but many of these can be overcome when using MIRR or Excel's XIRR function instead. Using the latter tools introduces some of the same problems that NPV does though.
In general I think folks should spend a lot more time learning to market and source deals so they can be selective than learning abstruse finance concepts that really fit better for larger investments. The finance machinery matters more when you're trading larger assets like large apartment complexes. I think technique and access to greater deal flow to be more selective matters more for small assets that most on this board trade in.
@Ned Carey If I knew the future value of everything, then I wouldn't need to do an analysis. You need to assume the final value of the asset or would you assume the final asset is $0.
@bryanhancock you are up late / early for Austin. The discount rate I use is how much I typically make investing my assets elsewhere. Good points on using IRR, but if I'm capital constrained I'm probably not investing.
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.
As usual, completely agree with @Dion DePaoli...
In terms of Dion's point about NPV not losing utility for large or small projects, it's worth pointing out that I used to work for a very well known tech company that pretty much relied solely on NPV calculations to make all product decisions -- from launching a new subsidiary to deciding whether to add a new button to the user interface.
If NPV > 0, work was done. If NPV < 0, work wasn't done. That simple. Of course, like I said above, this particular approach generally only works when capital is essentially unlimited, but drives home the point that in some situations, NPV is very valuable.
If you're selecting a hurdle rate you're implicitly making assumptions about risk. Why I think the analysis falls short for small projects is that it is very difficult to price risk. If you're looking at large exchange-traded companies the market does a pretty good job of pricing assets and data can yield volatility, variance, etc. figures that would aid in establishing mathematical defintions of risk for a given asset. However, if you're the ONE buyer for a single distressed asset you may be doing a horrible job of pricing risk for the asset.
I agree that there is really nothing wrong with the calculation from a strictly mathematical standpoint. The problem is that selecting the data to insert in the model is problematic when pricing illiquid assets for investors. Pretty much any granular model with be a GIGO machine if one doesn't price risk correctly and thus selecting significant digits down to the penny for precision is dubious at best.
The WACC for small projects that one would use as the discount rate in a NPV calculation is impacted by the investor's required return on equity, which necessitates that one price risk properly. It also is impacted by the cost of debt. If one can no longer take on new debt or the price of future debt is impaired it is difficult to quantify the impact of a single project's debt burden precisely. Saying that one can quantify it to two decimal places is complete nonsense.
Larger projects are traded using more elaborate models in many instances and they still suffer from GIGO problems. A sensitivity analysis does help a lot here and there are some key variables that dominate many models; like rents, vacancies, etc. Stable credit tenants also yield a more precise analysis because economic vacancy has less variance and thus the asset is more bond-like where a NPV calculation would have better meaning IMO.
The whole problem I see with using NPV is that users get a false sense of security when they bake the numbers. Oh, the NPV is $13,566.47. It must be good! Saying that you have all of the information to price the discount rate appropriately and thus come up with a figure this precise is complete nonsense to me. IRR is more heuristic to me although it suffers from many problems as well.
If the concern is that the discount rate can't be accurately determined due to the difficulty in defining risk, then by-definition, IRR has the exact same issue as NPV.
If the concern is that the discount rate can't be accurately determined due to the difficulty in defining risk, then by-definition, IRR has the exact same issue as NPV.
The rate input to the NPV calculation is big guess based on one's perception of risk, thus, as Bryan says, a GIGO machine, I agree. The cash flow inputs to the IRR calculation are much easier to guess at. I don't see at all how they suffer from the exact same issues??
True, but using a single discount rate signals one's inability to properly account for risk. Fine-tuning discount rates at multiple stages of a project to arrive at a NPV with ultra precision is ridiculous. A more heuristic comparison of an IRR with a single discount factor to one's cost of capital seems to paint a more realistic picture of what one's analysis yields if you ask me.
A lot also depends on the duration and nature of the project. No one tool is the proper one to use for all projects. I know the intellectuals fancy NPV, but they hand-waive away the problems with ACCURATELY forecasting discount rates for distant cash flows in projects. The idea that someone can know the PV of something this accurately is ludicrous; especially with many of the trades discussed on BP. Thus the more blunt instrument approach of using an IRR calculation and comparing it to one's cost of capital seems like a more logical approach to me.
To each his own. Fundamentally I disagree that anyone can forecast distant cash flows with any degree of accuracy and thus the idea that a NPV can add more precision is dubious at best to me.
The rate input to the NPV calculation is big guess based on one's perception of risk, thus, as Bryan says, a GIGO machine, I agree. The cash flow inputs to the IRR calculation are much easier to guess at. I don't see at all how they suffer from the exact same issues??
The output of the IRR calculation is a discount rate. Ultimately, that discount rate will need to be compared to the cost of capital to determine if the project has a positive expected present value. If you can't adequately account for risk in the NPV discount rate input, how do you adequately account for it in the IRR output comparison to cost of capital?
I completely agree. :-)
Well, agree with some of what's been said above, most have the right idea as to the applicability of the NVP analysis.
Drill down, the NPV is searching for the value of a project (better to say use of funds) over time and translated into present dollars to compare to other alternatives. It should not be used to determine a RE project by itself, or evaluate risk. The NPV is only part of an analysis but doesn't give the end solution.
Kind of like saying I'm going to put wheels from a school bus on my BMW Z-3 ( a small 2 seat sports car) and make it go faster. Considering the diameter of the wheels and the RPM of the engine and concluding the car will go faster is a bad conclusion.
In RE, the NPV is used to value a long term lease or better, an option. What is the value of the option price. Here, investors set option prices from a market basis, getting all the can, but the option price can be determined through a statistical analysis utilizing the NPV. That won't ever be done here as I've never seen anyone here trying to value an option on a $15,000,000 property over 5 years or in paying for any first right of refusal (most here try to get these for nothing).
Just saw a government analysis, each new home built is equal to 3 full time jobs for one year at the average income and $90,000 in tax revenues. Now, this is the type of analysis where the NPV would be applicable.
Students of finance attempt to apply theory where it doesn't really belong as it's not applicable. Being aware is a good thing but trying to work with small amounts, say less than 100K monthly in cash flow just won't yield reliable information that has real value. That's because other variables are not reliable and the costs of the analysis is not really productive. Dealing in a 160 million dollar discretionary budget, the capitalization rate is usually set to known rates such as T-Bills, and is used to determine investments and the maturity distribution of the portfolio. I can tell you, in government and banking, heads will roll if unused funds are not invested daily !
Agreed, look to "Managers Internal Rate of Return" this will be more applicable to RE investors.
Garbage in garbage out, opportunity costs are great when you have known alternatives on the table, otherwise you're guessing. For example, saying the net takes out fixed, variable and contingent liabilities over time. Are you going to consider inflationary issues with variable costs? What about fluctuations from investments from cash flow over time earned from that project or original investment, you'll find yourself in what might seem to be an endless loop. Just saying, the NPV really only applicable in certain evaluations, with large numbers, with reliable cap rates and a term of time with limitations or under a controlled economy.
Another issue is the term of analysis, the further you go out the less reliable your analysis due to economic factors and market demands, especially in a globalized economy. If you think you can determine such future factors, you need to get out of RE and do something else that would be more profitable. (LOL).
Finance is an art and a science, the science is dealing with known data, the art is in knowing when the data is applicable.
The NPV is rather simple, it can be made very complicated and beyond useful. You'll burn up the engine and tranny in that BMW turning those bus wheels up a steep hill. The entire vehicle must be designed to accomplish its use. :)
First, let me say, I love the serious debate. Second, I respect the opinions expressed here, some of the great minds on BP. Third, I still wish to defend my stance and jab at some of the ideas expressed.
First, the idea that laymen are incapable of evaluating and determining their risk is something I don't agree with. Every investor, when they become an investor, evaluates risk. They must, or they would never choose an investment. The idea that I must somehow have a PhD to understand risk, to me, over complicates reality. Eddy investor, if he is at a point of making investments with his own money, clearly has an idea of what his risk tolerance is. It seems the counter opinions desire some large amount of complexity to the deal. Then the argument here, is that by the nature of the investment being less complicated, somehow the equation which can be used in the evaluation of a complicated project no longer applies to a lesser complicated investment. A little bit of a circular argument in my opinion. No wonder Eddy is confused.
Eddy has $20k. He wants to invest. He chooses RE as the asset class he wishes to invest in. Right there, an evaluation of risk just occurred. Eddy choose RE instead of say stocks. So then, Eddy steps into the world to find RE investments and evaluate them. Clearly this happens, as Eddy has more investments than he has capital to choose from. So, the act of narrowing down the potential investment pool is also an evaluation of risk. A simple example is choosing RE investment in Eddy's town opposed to 5 states away. Why did Eddy eliminate the out of state investment? He did not like the risk of managing or owning so far away.
So now, Eddy has a smaller population of assets to choose from to invest in. He went from 1,000's to perhaps 100's. As Eddy continues to apply filters to the population of potential investments, by adding his criteria, he is addressing risk. From the local 100's of choices, he further filters to say Duplexes. Now bringing the population selection down to a more manageable number.
Then Eddy has 5 assets to choose from. Eddy begins to build some cash flow model for the investments to compare. As Eddy calculates the numbers, he is going to be reviewing his invested capital and the return capital. The time each goes in and comes out. Amongst the 5, one needs more in repairs but is lower price or one has lower occupancy thus lower cash flow, one has lower cash flow but higher occupancy, one has Seller financing and one needs no repair and has high occupancy but higher price. That is easily a real world example and I didn't really even try to make too much up. Again, if we think Eddie is incapable of judging risk, then he makes no further decisions.
We know that is not true as Eddy buys RE (as a group of individual Eddy's) in the market everyday. Somewhere in this level Eddy will start to quantify these deals with math. Eddy will at least calculate input and out of cash. Eddy will come to an idea of what type of investment horizon he wants or should have. Eddy will make, even if in his mind, a list of pro's and con's for each. Only now, there is, even in laymen, a quantification of each possible investment. He will choose amongst the 5 based on the pro/con list and the quantification. In that quantification, he will be calculating his return, even if basic as Net Profit/Total Investment.
Will Eddy simply choose the highest number? No, generally not. Eddy, as a laymen will make a rational decision based upon his own bias and desires to continue to eliminate or simply isolate one of the 5 investments to make. By doing so, Eddy is looking at Investment 1 with a 20% ROI (which is the laymen calculation he used) and Investment 2 with a 15% ROI. Simpy by the nature of the ROI numbers, the investments are different and thus risk is essentially different. Yet Eddy still chooses. As soon as Eddy chooses Investment 2, Eddy has associated the risks he has established in Investment 2 with the ROI number. Forever creating a baseline of comparison for future evaluations.
Eddy, has just completed his first risk assessment and is even armed with a notion of what type of Hurdle Rate he thinks he should have/deserve. Not only was he capable, it happens millions of times per day.
(I am trying to split my thoughts to not make such a long single post)
So, laymen can certainly access risk. Does the laymen do a good or bad job of accessing said risk. Certainly, only so far as Eddy understands the risk. Perhaps one of the assets he didn't choose had sewer line problems and Eddy realized he doesn't know enough about that concept and doesn't feel comfortable taking it on. So he would rationally eliminate it.
Can Eddy suffer from not knowing what he doesn't know? Yes, but so can any other investor. Eddy's barrier is the lack of repetition. As he does more deals, he understands the risks better and sees risks he didn't see before. As such, Eddy also becomes capable of quantifying said risk. That may even be primitive in its evolution, sewer line broker equals bad, I suppose. He doesn't need to know the detail of it, just to avoid it. He will however, continue to filter asset selection down and in some fashion make a comparison of what he believes the potential return is or could be amongst the population as a means to help select the next investment.
Aside from the experiencing method of being able to judge risk (in its basic form) Eddy is active in the community and hears conversations about return rates that others get. This will have an impact on Eddy and likely played a role in the selection of Investment 1. Eddy hears and begins to believe that 15% is a good return rate. Even if it is simply because that is what other people want too.
So Eddy has a Hurdle Rate. The NPV formula needs a Hurdle Rate. Seems to me, he can simply plug it in. No PhD required.
So then the argument evolved to, well Eddy by way of lack of experience will not begin to understand the different layers of complexity of a deal. The utility of NPV will break down due to the lack of liquidity or the failure properly structuring the model. Again, this is not a reason to not use NPV, this is a reason not to cross the street, because you might get hit by a car. Of course, Eddy needs to have an understanding of the evaluation he is doing if he is going to use math. The argument made in that manner against NPV can be made for any math equation anywhere.
I, frankly, would argue for this reason it is better to teach Eddy how to use this as NPV will bring to the table barriers in the analysis. Eddy can't use NPV unless he knows how to use it. Knowing how to use it, is knowing when and how to set it up. All that said, Eddy is not modeling out some complicated portfolio. Eddy's evaluations are typical to a Duplex, and frankly NPV works just fine, provided Eddy can set up the cash flow table. If Eddy doesn't know what Net Cash Flow is for NPV, he will not know for any other evaluation either, so they all fail.
To me, Eddy should learn how to use. Certainly not in step 1, but as Eddy becomes a more and more experienced investor he will not only be capable but will benefit from its use. The alternative for Eddy was starting from a place with less skill and knowledge, so when we look at the alternatives for Eddy's quantification, they are actually less informative and in general. Simply compare ROI to NPV or IRR. Present Value, Internal Rate of Return and Net Present Value are all related ideas both in concept and in arithmetic. If they work for the complex, they work for the not complex as the idea of analysing complex risk is simply reducing the complexity. Understand additional complexity of risk is a function of experience. The same argument against NPV in that manner can be made for doing any math at all. Don't add your expenses, etc in, you could be wrong. I know we don't agree to that idea, but that is the base of this argument.
I completely agree. :-)
How does this concept not circle back on the output of IRR is the Hurdle Rate?
"A more heuristic comparison of an IRR with a single discount factor to one's cost of capital seems to paint a more realistic picture...."
Using one or the other has more to do with the supplied inputs not the output. If I know what IRR I desire, I can use an NPV. If I don't have a Hurdle Rate, I can evaluate what the IRR is independently. Whether the output IRR becomes a standard Hurdle Rate or a Hurdle Rate circumvents what each equation on its own set out to accomplish.
You can't estimate a proper hurdle rate with any degree of accuracy for distressed real estate projects IMO. You can, however, pretty accurately compare the IRR for a project with one's individual cost of capital. Investors tend to know what their cost of capital for a given type of asset much more accurately than far-distant discount rates for a given project.
I do agree that most modeling is guesswork. There is a reason that economics is a social science. None of the measurements are perfect and imputing a greater degree of accuracy than is merited is silly to me.
@Dion DePaoli , this doesn't make any difference to your point but when I plug your earlier example into excel I get something a little different ... am I wrong or you?
NPV = ($11,776.01)
where,
Hurdle = 0.12
P(0)= -20000
P(1)= 1000
P(2)= 1000
P(3)= 1000
P(4)= 1000
P(5)= 1000
P(6)= 1000
P(7)= 1000
P(8)= 1000
P(9)= 1000
P(10)= 1000
P(11)= 1000
P(12)= 1000
P(13)= 1000
P(14)= 1000
P(15)= 1000
@Account Closed you are not properly setting up the NPV equation.
Whereas cell reference in excel:
A1 = P(0)
A2 = P(1)
=NPV(A2:A16)+A1
Period 0 is not in the NPV cash flow.
You can back solve this with PV to check your answer:
=PV(12%,15,-1000,,0)
The present value of that cash flow is $6,810.86
The "Net" Present Value is ($13,189.14)
Excel doesn't do a good job of explaining this idea which does mess with folks. It is widely known by folks who use NPV. Nonetheless, don't include the P(0) in the cash flow like you would with IRR. We can also confirm as we did above with the PV or we could confirm with long version of discounting the cash flow.
Bryan, we must be on the a different page with our definition of Hurdle Rate. You almost talk about this concept as if it something that 'I must have correct'. Opposed to what it actually is, a 'Hurdle'...the minimum acceptable rate of return.
If I want to make more than a 15% return, then my Hurdle is 15%.
We use Hurdle Rate, NPV, PV and IRR every single day and all we purchase is distressed real estate assets. Mind you, we make a habit out of being accurate. So from my perspective, your statement is not true.
When using NPV, I agree, I must have a notion of why something garners a 15% hurdle opposed to a 12%. But even that is not all that complicated, risk ratio logic says the greater the return, the greater the risk and vice versa. And in my previous thesis, I at least argue that everyone is capable of risk assessment to some degree.
To the idea of whether risk is properly allocated to a project and therefore the acceptable IRR, I could even argue is not a required knowledge of the investor. The market will help guide that too, as it does all the time in real estate. If investors run out and purchase A Class property with a 5% Capitalization Rate, they are setting a Hurdle Rate. Similar properties will sell for similar rates of return. Usually the market will force other investors to follow suit or they simply will not be able to get to make an investment.
So even the investor who says, perhaps improperly by somebody's standard, 12% is the correct hurdle for that investment, is subject to the rest of the market's opinion, which will find its own equilibrium.
OMG!
Bryan, I agree, IRR is appropriate. Right track
Dion, your layman just did an investment analysis, but not a risk analysis.
Risk is the probability of loss, assigned as a weighted factor to much of Eddie's thoughts to alternative investments to make a decision. The NVP is not a computation in risk analysis but in the use of funds.
No one quantifies risks at the investment level of the types of investments available to "small" RE investors here on BP. They may take a stab at it thinking they are as a way to justify spending time having coffee, puffing in forums, but they are kidding themselves while blowing smoke and blinding others trying to learn something.
Everyone bypasses the math and uses gut instinct, common sense and experience from past dealings, as Dion points out. That's the best way and most reliable way for small investors to evaluate risk in any deal. Risk analysis relies on the law of large numbers, significant populations that can be measured, identified, quantified and where loss can be demonstrated and without such factors you can not identify risk quantifiably, you're guessing . No one here has such data. Fannie Mae has such data, Frankie the investor does not.
There are those who love to play with calculators and software, heck, it's fun, it helps us see relationships between various factors, but at this level, you're wasting your time. Ask anyone who has taught finance, accounting and economics about students who comingled theories of any of these subjects with another one and they will show you where they pulled their hair out. As Bryan pointed out, injecting economics into finance can quickly become a square peg in a round hole. Are we still on topic? :)