Net present value (or NPV) is a real estate investing
measure widely used by investors for investment real estate
analysis for a specific purpose: Net present value tells
the investor whether his or her target rate of return will
be achieved by a property and in turn, whether the property
should attract the investor's capital into that investment.

Here's the technical interpretation.

The net present value model is based on a decision rule
that states if the discounted present value of future
benefits is equal to or greater than the cost of those
benefits it is a profitable opportunity. Whereas, if the
present value of the future benefits is less than the cost
for those benefits, the rate of return will not be achieved
and chances are good that the investor should take another
look.

Okay, let's frame the idea with a simple illustration.

When you place your money into a savings account (i.e.,
invest your capital) you expect it to earn interest (i.e.,
provide future benefits). The bank dictates the return and
you are either willing or unwilling to tie up your capital
based upon your acceptance of that return. For example,
whereas you might deposit $10,000 to earn 3.8% interest,
you might not make the investment to earn 1.2% interest.

Now suppose a bank doesn't quote an interest rate. Let's
say you are only quoted what amount of money you'll collect
in the future. That next year you will collect $10,300 with
a deposit of $10,000 today and there's no mention of
interest rate. How would you know what yield your
investment is earning?

That's the dilemma real estate investors face when
analyzing income property. Whereas there's a projection for
an investment amount and future benefit, there's no mention
of yield. The individual investor has no idea what rate of
return is achieved based upon that data alone and therefore
has no way to compare it to other potential investment
opportunities adequately.

This is where net present value comes in to play.

NPV takes your desired rate of return and shows you whether
the future cash flows (benefits) from a property are
adequate enough for you to achieve that yield on your
capital investment. In other words, you state the yield you
want, and NPV will inform you whether that target yield is
achieved.

How It Works

NPV discounts all future cash flows by the desired rate of
return to arrive at a present value of those future cash
flows, and then it deducts that amount from the initial
equity, or initial capital invested. The result is a dollar
amount that will always be either negative, zero, or
positive.

How to Interpret

1) Negative dollar amount - This means that the present
value of future benefits is less than the amount invested
and that the specified rate of return is not met. In other
words, you might want find another property to make your
investment.

2) Zero dollar amount - This signifies that the present
value of future benefits equals the amount of the
investment and that the desired yield is perfectly met. In
other words, the property will achieve the return you want
with nothing to spare.

3) Positive dollar amount - This reveals that the desired
rate of return is met with room to spare. In other words,
you might have come across a keeper.

Net present value is certainly worth knowing, and when
properly used can help you evaluate your next real estate
investment opportunity. Just bear in mind that it is only
one small aspect of real estate investing analysis, should
never dictate an investment decision, and is certainly not
without its shortcomings.

Yes, NPV will provide you the opportunity to evaluate
projects using the same rate of return requirements, but it
will not provide any useful information concerning one
project over another from a risk standpoint.

Finally, I should add that it's impractical to calculate
NPV without a financial calculator or quality real estate
investment software. If you are serious about real estate
investing then by all means make the investment in a good
real estate software solution that computes net present
value and provides other real estate analysis features that
will benefit you as well.

Here's to your real estate investing success.

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James Kobzeff is the developer of ProAPOD - leading real
estate agent software solutions since 2000. Work with
rental property today. Create APODs, proformas, and other
rental property analysis presentations in minutes. NPV and
other returns computed automatically! Learn more at =>
http://www.proapod.com

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