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.
I see: I was discounting the initial outflow when it was already part of the present value.
Another observation: The difference between the PV and NPV formula is nothing more than the format of the input; Same as, the difference between the Rate and IRR formula is nothing more than the format of the input. In both cases, one formula accounts for unequal cash flows where the other only accepts equal cash flows, other than the unevenness of the cash flows the math is the same.
Thanks for clearing that up.
With uneven cash flows you may need to compute over the periods which are the same, bring that to the PV and compute each change with a shorter term. :)
I was just trying to play nice above and end the conversation... :-)
The way I see it, the output from the IRR is exactly the same as the input to the NPV (discount rate/hurdle). If you don't know what discount rate you have/want/need, both NPV and IRR are going to be equally useless.
Personally, I consider my discount rate to be my cost of capital. If I want to account for risk that I can't quantify, I do it qualitatively, as -- by definition -- I've already determined that I can't quantify it.
NPV and IRR are just two sides to the same coin. IRR provides more "color" but ultimately, without a meaningful discount rate, they are equally useless.
Just my $.02... (and my understanding of math)
Bill, I think our posts overlapped a little.
But, "Eddy" (not Frankie, gesh), did a risk analysis. When I choose any number of preferences, that is a risk assessment. I like SFR better than Condo. Personal preference or risk assessment? Well why do you have a preference? In the investment world, isn't preference a risk relationship otherwise there is no need to determine Investment 1 or Investment 2, they are equal.
I guess I am arguing, risk and its assessment is not a monopoly owned by those who can crunch numbers. Risk assessment is also not such an abstract idea. Do I walk down a dark alley on a bad street or use the sidewalk under the lights? Risk is assessed, even if not quantified per se.
Risk is indeed, the evaluation of potential loss and gain. I could lose my wallet in the dark alley but I will get to my destination faster. I could get to my destination slower and not worry about losing my wallet.
If you put a 15% hurdle on something, that is a risk assessment for sure. Is 15% the 'proper' hurdle to use? That answer can be answered but only in terms of market, where other investor taking similar risks use a similar rate. In that setting, if I use 12% and you use 15%, the bi-product is I can pay more. Is that right? Well it is not wrong. Both could be understated or overstated equally. If I lose or fail to achieve my target return, then in future offerings I adjust my hurdle. If you make offers and they are rejected, you will adjust your hurdle down to get into more investments.
I agree with @J Scott . Which he stated in much less detail than I but it is the center of my argument. They are the same. To throw one out is throw both out. Not doing something properly, like the correct treatment of net cash flow is a problem for both. So we can't say NPV fails because of that because IRR would fail too.
NPV answers the question, is this cash flow above or below my [Stated] hurdle.
IRR answers the question, what is the hurdle.
The equations are not used to answer the same question.
Problem is we often say we are assessing risks on BP when in fact we are not really assessing risk but rather seeking an investment decision. Eddie did not do a risk analysis by definition. If that's what we want to call it here on BP that's okay, or at the office, but let's not take that to any more sophisticated financial forums as it is not correct. In our little pond we can float over that, what you're really saying is that you're making an investment decision based on qualitative information by experience into the investment analysis. If I'm following you.
Past experience, learned or perceived, tells you not to walk down that alley with ten grand in your pockets, the risk may be different with ten bucks and you may decide to take the short cut.
Changing the amount of money to carry does not change the risk of getting rolled, but it does change the risk of greater losses. Two different things. :) .
I do not understand why there is a tendency to exclude a small capital investor or single investment into a world that has no complexity. We were just doing that with NPV and now we are doing it with risk assessment. It is injustice.
To say Eddy's risk assessment is simply a qualitative investment decision omits that the particular idea may be qualitative in nature but it matters because it has a quantifiable root. It also implies that all risks are quantifiable, which they are not.
Risk is devation from an expected outcome or dispersion from a tendency. The human mind processes risk and even performs it by standard deviation in your everyday activity. Walk across the road, riding a bike, tasting hot soup, all have this similar practice. Whereas, we don't know the exact outcome but statistically we believe it to end up like X. 80% of the time X should happen. Etc.
When Eddy says I want a SFR instead of a Condo it is not random, and frankly especially IF Eddy makes that criteria, he has conducted and concluded a form of risk assessment. Perhaps he feels renting a condo is hard than an SFR or perhaps he is concerned the value of a condo can decline faster or he might have exit issues with a condo in the future. The list goes on, some of those are easily translated into numbers others are not. If that is still too abstract to realize it's true, surely we can see something like rental rates and sale price fall into this example pretty easy. Does he know the exact number, no, but he conducts a risk assessment and decides to pursue or no. If Eddy thinks there is a higher percent chance Condo values fall faster than SFR values, he would logically choose to pursue SFR. The decision had to come from somewhere, didn't it? In high level appearance, it may seem to lack quantitative backing but under examination it is present. That is also what is learned as Eddy becomes more experienced. How to quantify his risks, which make him a better prudent investor.
In it's most simple and elegant form, the idea of return is an assessment of risk. They are forever entangled and inseparable. Investor new and old, large and small have equal capacity to determine risk. It is not unique to one category of investor and not the other. It can't be, there is no right or wrong answer. When we do exclude these concepts such as equations or formulas or concepts to the 'institutional guys' that, sounds like something that is said to a child, "...you are not old enough for that yet..", etc. I prefer to look at it with the notion that, it's about time you learned this and it is valuable, that is why 'they' use it.
The difference has nothing to do with the sophistication of the investors. In fact I think many of the institutional crowd are pretty clueless and have never had to go out and raise actual capital to learn how equity investors assess risk.
The fundamental difference is that the types of investments traded on this board are, for the most part, illiquid with little data to establish variance or any quantifiable data like one would get from uniform assets traded on an exchange. Saying that one can accurately price risk into a discount rate for cash flows several years from now is dubious enough with exchange-traded assets. In my humble opinion it is completely ludicrous to do this for distressed assets with unique financial structures for each transaction. Those that feel like they're being more precise by doing so are kidding themselves in my opinion.
Fortunately that is what makes for a market so everyone can just do whatever they want and think whatever they want. I can't see that anyone is making any new points in this thread from the last several entries so the readers can decide for themselves what they believe.
Bryan/Dion/Bill - These are some great discussions. I am new to real estate so probably don't know what I am talking about, but I guess that is the purpose of these forums. I am one of those excel monkeys that like to crunch numbers etc. and I tend to use IRR for understanding value and will admit that I probably don't fully understand the investment risk (learning). So, I think people agree, understanding the risk is difficult, which then makes picking a hurdle rate difficult. Why not approach the problem with the mind set that you won't pick the right hurdle rate so try to provide some margin in your assumptions? That way even if we get the hurdle rate wrong we have some room. Here is my newbie approach for trying to see if a market is somewhere I want to be.
1. Research the market area. Figure out comps for rent and pick a number to apply to the property. Now reduce that number to something lower.
2. Research vacancy rate and pick a number that represents the market vacancy rate. Now increase that to something higher.
3. Assume 0% appreciation.
4. Assume that income and expenses escalate at the same rate. Maybe assume expenses increase more than income.
5. Assume 50% expenses, seems reasonable.
6. Crunch the IRR. How does that number compare to a "riskless" investment, say a government bond. Lets say bonds are at 5% and your IRR is 10%. The question I would ask is whether all this work is worth a 10% return if you could make 5% doing nothing. Maybe you can do a sensitivity to determine a range of IRRs
Appreciate your feed back and if I missed this discussion already above, apologize, there was a lot of material to read through and back and forth.
Jared
Hello All!
I am a MF investor. I like using NPV in the calculations for my APOD analysis. I am going to run through how I conduct my analysis. Please criticize if anyone sees anything that could be modified. I have a couple college degrees, but not in finance.
My discount rate is 10%. I want to compare all the investments to the same discount rate. I use this across the board.
I take the Adjusted Sales Price (what I think I can purchase the property for) and the current rent rolls.
I then appreciate the rents annually between 1% and 3%. It depends what part of town the subject property is and how much below/above the current rent roll is at the subject property.
The expected sales price (if sold in years 3,5,7, and 10 of ownership) is then adjusted by the appreciation of the rents.
I appreciate the expenses by 2.5% at a Year 3 sale, 5% at a year 5 sale, 7.5% at a year 7 sale and 10% at a year 10 sale.
I use the year 3,5,7 and 10 sales price (deduced from the appreciation of rents and the appreciation in operating expenses) to determine my NPV for each hypothetical year's sale.
I also factor in closing costs, commissions, etc...
This is not the only factor I use in determining whether or not to make a bid on a property. It does help me though. I believe its most useful determination is the equity realized upon the purchase of the property.
If the NPV, for example, is $25,000 on a year 3 sale and $27,000 on a year 5 sale, conversely the IRR will typically be higher in year 3 than years 5,7, and 10. The property should not be held longer than 3 years. The equity I have built within the first 3 years does not grow exponentially. It plateaus. My equity growth within the subject property becomes stagnant and my money should be allocated to another investment.
Thoughts?
@Jared Foster , sorry didn't notice the comment here. A couple thoughts on your comments:
@Daniel Miller to address your post:
I don't think anyone here will say your right or wrong, again, speaking to the spirit of the thread that is the debate, how to access risk and is it quantifiable.
To me, it seems like you have a lot of moving pieces which are assumptions. So the influence of one assumption, which impacts assumption #2 can amplify you in either direction. To this degree, that is some of what was/is being debated or at least creates some of the basis of this discussion.
It does seem that there is a persistent idea in your assumptions that all things go up over time. Certainly, that may not be reality. Rental rates can decline. So then, in reality if rates do decline, the further out you are with an upward trend, the more wrong (sounds weird) your number will be.
If income increases and expenses increase, the impact only comes from the net effect whether flatt, positive or negative. I think you just have to be careful that as you turn both dials that you are not exaggerating either one's affect. Again, to some degree, that is the spirit of debate. That RE investing analysis as it trends into the future becomes less and less accurate because we can't know how that particular feature of the model will truly react. My only advice would be to try and understand what isolating those effects do and remember to stay to the side of conservative assumptions.
I am not positive you are calculating and interpreting NPV properly. I don't understand how you believe NPV is illustrating equity at period 0. In its nature, NPV and IRR are time value of money calculations, if there is no time factored in what you actually measuring?
Further, in the $25k and $27k idea, those make me believe you are not setting up the equation properly or are misusing/interpriting the formula output. There would be a natural increase in any calculation output as you have an additional year(s) of income which will naturally increase the return if all other inputs are equal. That will be the case for NPV, IRR and PV.
I don't understand how, with additional time, which means additional income, you see any plateau.
I may not have fully understood your setup and or interpretation of the results.
The properties I run through my analysis are ones that are specifically chosen to have a higher than average probability of rising rents. I do not analyze properties in the ghetto or shady parts of town and I do not analyze any properties that are in tip-top condition. There has to be a certain value-add potential to any property that I anticipate making an offer on. I search in parts of my farm area that will, more than likely, rise in rents and/or have undervalued rents to begin with. I should have explained my analysis parameters.
As far as my use of the word plateau, that was incorrect. It never does plateau. The NPV always rises due to the appreciated rents compensating for more than the increase in operating expenses. If I anticipate being able to raise rents (and/or the market calls for increased rents) I will set the appreciation of rents at a higher level. In this sense, if I purchase a property with a small NPV, but the appreciated rents anticipate (for example are 3% annually) this is typically a better property to hold and sell in years 7 or 10. The NPV will increase exponentially over the holding period.
Conversely, if I purchase a property (like my previous example) with a year 3 sale attaining a $25,000 NPV and year 5 sale a $27,000 NPV, it does not necessarily plateau but the equity has been "realized" in this investment and the IRR decreases every hypothetical sale year after year 3. The NPV does rise, but it does not increase enough that it makes fiscal sense to keep the equity already earned in this investment.
BTW, 99% of the properties I look at are MF.
It is fun to get creative with this stuff. These are all just tools to help me compare different MF investments. No calculation will be without flaw. If anyone has any advice on what they would do differently please let me know. I am always tinkering with my analysis.
Thanks
For any new investors, Dion's post above should be read over and over. To summarize his post:
However conservative you're being with your analysis, be more conservative.
The NPV does rise, but it does not increase enough that it makes fiscal sense to keep the equity already earned in this investment.
It's quite possible that I just don't understand NPV well enough, but this sentence doesn't really make sense to me...
How does $X increase in NPV translate into a decision to keep or dispose of the property? An increase in NPV only tells me that you're continuing to surpass your hurdle/discount rate, not whether the deal is better or worse than other opportunities you have with that equity/value.
An NPV that transitions from positive to negative (or vice versa) gives me information about the value of the investment, but I'm not sure how to use a discrete change in NPV from one positive value to another to generate any useful information.
Conversely, if I purchase a property (like my previous example) with a year 3 sale attaining a $25,000 NPV and year 5 sale a $27,000 NPV, it does not necessarily plateau but the equity has been "realized" in this investment and the IRR decreases every hypothetical sale year after year 3. The NPV does rise, but it does not increase enough that it makes fiscal sense to keep the equity already earned in this investment.
I am struggling to follow this to some degree in terms of realistic impact.
In order to set up an NPV calculation, you need the net cash flow during the holding period of the investment. How can you have a large or small NPV in terms of purchase price? The price, is the price, it isn't an NPV, there is nothing to calculate NPV from with just the price you have no periodical net income.
So then, if you purchase an asset with a smaller initial capital injection opposed to a larger injection, of course that will show better numbers. A small number is easier to catch up to and exceed in shorter time. Which takes longer to break even on, $10 or $1,000,000?
Additionally, NPV is not the same as equity. I don't understand how you are correlating these. Simply add debt to any investment to illustrate the idea flaw. Your equity will be earned as a function of principal reduction and appreciation/depreciation. So, you can have an asset that depreciates or simply deteriorates and still have good cash flow with a suitable NPV. Take every dollar from rental income and put zero back into the asset for repairs, you lose equity but you still generate return in that sense.
Do you want to detail your two examples, I am interetered and perhaps am simply misunderstanding the posts.
@Daniel Miller just sending you a nudge not sure the mention functions let you know about the mention. (reported already)
It's quite possible that I just don't understand NPV well enough, but this sentence doesn't really make sense to me...
How does $X increase in NPV translate into a decision to keep or dispose of the property? An increase in NPV only tells me that you're continuing to surpass your hurdle/discount rate, not whether the deal is better or worse than other opportunities you have with that equity/value.
An NPV that transitions from positive to negative (or vice versa) gives me information about the value of the investment, but I'm not sure how to use a discrete change in NPV from one positive value to another to generate any useful information.
J Scott,
Let me rephrase this sentence. I need to proofread these posts more carefully.
If my analysis shows that the NPV from a sale in year 3 is $25,000, and the NPV from a sale in year 5 is $27,000 than it is more than likely a better financial decision to dispose of the asset in year 3 and realize the equity you have made in the investment, as oppose to waiting two more years to sell it and only adding $2,000 more to the bottom line. So, the NPV does rise, but it does not rise enough between years 3 and 5 that it makes fiscal sense to keep the investment beyond year 3.
Dion, is there anyways I can attach my spreadsheet that I created and you can look at it? If not I will run through the example. It is going to be a long post. I dont mind doing it though. Please let me know.
Dan
@Daniel Miller my email address is at the bottom of the signature in my post. You can just use that. I don't know how to attached something to a BP message. I can take a look at the excel file and comment back perhaps provide some summary to keep J Scott in the loop too.
@Account Closed ... I am not sure how you would use NPV in most real estate deals. Can you give me an example?
This really depends on the investor and nature of the deal. The net present value for instance would be a useful tool for many 'buy and hold' investors who acquire rentals, fix and rent the property (or properties) for a few years then sell them 5 or 8 years down the line.
The IRR would also be applicable for such analysis. The central theme is to determine what the present value of all future project cash flows are worth today.
If you are just buying and flipping properties in 6 months or less, from a time value of money perspective, there are probably more simple forms of evaluating shorter term projects and probably why there often isn't much mention of it here.
this is a great thread, thanks for the indepth analysis
To Quibble - NPV is Not "New Preset Value."
It is NET PRESENT VALUE. It means,
A bird in the hand is worth two in the bush. Or
$5000 now is worth as much as $10000 down the road a piece.
To get NPV you discount the future value over time by some rate such as ROI or inflation, or your preference for money now over money later.