What is NPV in Commercial Real Estate?
Net present value, or NPV, is a financial metric that helps commercial real estate investors determine whether they're getting a certain return or 'target yield,' given the amount of their initial investment. The NPV equation takes a building's current net cash flows and your required rate of return to determine a building's value to you, the investor, right now.
How Can Investors Calculate NPV?
Net present value is calculated using the formula below. "C" represents the sum of cash flows, "n" represents each period, "N" represents the holding period, and "r" represents the desired target yield, or required rate rate of return.
The Theory Behind NPV
The main concept behind net present value (NPV) is this: money now is more valuable than money in the future. For example, if you have $500 now, you can invest it and make even more money. However, if you don't see that $500 until a few years down the road, you miss out on the opportunities you had to make money during that time. In commercial real estate finance, this concept is referred to as the time value of money (TVM).
In commercial real estate, if the NPV of a property is positive, an investor pays less for a property than what it's worth. In comparison, if the NPV is zero, than the investor pays exactly what the property is worth. Lastly, if the property's NPV is negative, the investor is paying more for the property than what it's worth.
NPV vs. IRR: What's the Difference?
Internal rate of return, or IRR, is another financial metric which is closely related to, but not the same as NPV. IRR looks at the financial gain on each dollar invested. Therefore, IRR is the interest rate that brings a set of cash flows to an NPV of zero.
For example, let’s say you are considering purchasing a $1 million office building and selling it in 5 years. If the building’s anticipated annual cash flow is $100,000, and your required rate of return is 12%, you could plug this into the NPV formula. You would find quickly that the IRR for the building only reaches 11.59%, leaving you with an NPV of $984, 687. In order to achieve your desired 12% IRR, you need to purchase the building for $984, 687 or less.
The Limitations of NPV and IRR
Keep in mind that NPV does not compensate for uneven cash flows. If, in the previous example, the building generated $0 in years 1-4 and $500,000 in cash in year 5, the NPV for that period would be the same. Likewise, IRR does not compensate for the size of a transaction; the IRR on a $1,000 investment that returned $4,000 would be higher than the IRR for a $10 million investment that returned $30 million. However, most investors would likely be far more interested in the second deal.