(Net Present Value) Discussion and Tips
In real estate the best way to evaluate an investment is to net present value model the investment considering all factors including taxes & fees, which can become a bit of alchemy, in projecting future new & changing tax, interest & inflation rates & assuring it all calculates.
In finance, the net present value (NPV) or net present worth (NPW) is defined as the sum of the present values (PVs) of incoming and outgoing cash flows over a period of time. Incoming and outgoing cash flows can also be described as benefit and cost cash flows, respectively.
Time value of money dictates that time has an impact on the value of cash flows. In other words, a lender may give you 99 dollars for the promise of receiving $103 a month from now, but the promise to receive that same dollars 20 years in the future would be worth much less today to that same person (lender), even if the likelihood of payback in both cases was equally certain. This decrease in the current value of future cash flows is based on the market dictated rate of return and other factors like inflation, market factor & currency buying power.
Cash flows of nominal equal value over a time series result in different effective value cash flows that makes future cash flows less valuable over time. If for example there exists a time series of identical cash flows, the cash flow in the present is the most valuable, with each future cash flow becoming less valuable than the previous cash flow. A cash flow today is more valuable than an identical cash flow in the future because a present flow can be invested immediately and begin earning returns, while a future flow cannot and because the buying power of the American dollars has historically been losing value over time.
Net present value (NPV) is determined by calculating the costs (negative cash flows) and benefits (positive cash flows) for each period of an investment. The period is typically one year, but could be measured in quarter-years, half-years or months. After the cash flow for each period is calculated, the present value (PV) of each one is achieved by discounting its future value (see Formula) at a periodic rate of return (the rate of return dictated by the market). NPV is the sum of all the discounted future cash flows. Because of its simplicity, NPV is a useful tool to determine whether a project or investment will result in a net profit or a loss. A positive NPV results in profit, while a negative NPV results in a loss. The NPV measures the excess or shortfall of cash flows, in present value terms, above the cost of funds. In a theoretical situation of unlimited capital budgeting a company should pursue every investment with a positive NPV. However, in practical terms an investor’s capital constraints and risk sensitivity limit investments to projects with the highest NPV whose cost cash flows, or initial cash investment, do not exceed the available investment capital. NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects. It is widely used throughout economics, finance, and accounting.
NPV can be described as the “difference amount” between the sums of discounted cash inflows and cash outflows. It compares the present value of money today to the present value of money in the future, taking inflation and returns into account.
REAL ESTATE TIP #1, if you are the selling owner of real estate property do evaluate the impact of expenses & taxes on you and your transaction and do consider your exchange transaction opportunities; 1031 or other, if any.
REAL ESTATE TIP #2, If your buying real estate assure you have a positive net present value.