Commercial real estate investment can be attractive. Still, before you put your capital into a property, an important question is whether the investment will bring in potential returns.
Several factors or metrics can be used to answer the question. One of which is the net present value. As an investor, you must stay clear about it so that you know where you are putting the money and if it will bring good returns for you.
You will undoubtedly require a lot of research and understanding about the process and the measures used for identifying the correct type of deal, but it will be worth it when you get good returns from it.
The article will teach you about NVP and how it relates to real estate investing. In addition, it will provide you with clear insights about the metrics and various other information that you require for making the due diligence before the investment. So read ahead to get helpful information.
What to know about NVP in commercial real estate?
In CRE, NVP sometimes is commonly known as the discounted cash flow analysis. The valuation metric helps the investors understand the profitability they can expect from their potential investment.
It is generally calculated as a part of the pre-investment due diligence process. Therefore, when researching the investment, you must consider this factor a critical aspect.
Four inputs are needed, including the initial investment, discounted rate, future cash, and the holding time frame for the calculation of the NVP. When you have a clear idea, it will be easy to complete the process and check the profitability of the investment quickly.
The Discount Rate
An easy way to understand the discounted rate is as the required rate of return for the investor or the targeted yield that one can expect annually. It will vary strongly from one investor to another. It can be between 4% to 12% depending on the property location, type, interest rate, and market conditions.
Only with proper research and analysis of the NVP will one be able to put the money in the right place and enjoy maximum returns over the years.
The Initial Investment
It represents the initial cash that you will be receiving from the property. It is the amount you invested when paying for the property. The initial cash flow will be the same as the purchase price.
For instance, if you have purchased the property for $1 million and the investment is made in cash for the purchase, then the initial outflow will be $1 million. Therefore, it makes absolute sense when an investor is going to get a loan for the financing for most of the purchase.
In this case, the initial investment will be the difference between the loan and the property’s purchase price. For instance, if you have bought the property at a price of $1 million, then the investors can get a loan of $700000. Thus, the initial investment here will come out to be $300,000.
Future cash flow
In the case of CRE, future cash flow can be tricky to identify. They are all estimated by performing a projection of the income of the property debt service, expenses, and the taxes that one has to pay during the duration of the holding period.
Any model that is left after the costs are all paid off. This represents the cash-out flow the investor will receive from the property. For instance, if the property has an annual income of $100000 and the expenses come around to $80000, including the taxes and the debt, then the remaining balance of $20000 will be the inflow for the investor.
Finally comes the fourth important aspect for calculating the NVP in commercial real estate. It is the number of periods during which the investor plans on holding the property. It shows the investment is successfully made.
Of course, the period can be changed based on the condition of the market. However, the input here is designed to reflect the initial plan holding period for the commercial properties. The plan holding period is 5 to 10 years, but it depends entirely on the decision of the investor.
Once you have all the components required for the calculation of NVP, you will be able to know some of the future cash flow for each investment period. It will be discounted back to the present in terms of the chosen discount rate.
When the calculation is done manually, the NVP formula can be much more complex. This is different from the way the calculation is done. Now, the investors use the cash flow certificate for casting in a spreadsheet program.
The functions handle the accounting automatically for a given net cash flow and the discount rate. Thus, understanding things is hugely easier.
What do NVP results mean?
When you are calculating NVP for a potential property, then there are specific outcomes that you must be aware of.
When the calculation outcome is positive, then this shows that the planned purchase price will be less when compared to the current cash flow value at the chosen discount rate. This is a preferable scenario when the positive number will be more significant than the results. It will be better and suggests a great profit over the years.
When the result of the calculation turns out to be zero, it means that the investor is paying exactly what the cash flow he is receiving is worth for a given discounted rate and time frame. This also means that the discount rate will be similar to the internal rate of return. So zero is okay. This means that the investor is paying a fair price for the property.
When the result of the calculation is negative, it shows that the investor is overpaying for the cash flow at the chosen discounted rate. Of course, there can be scenarios where it can make sense. But it generally indicates that the investor should re-evaluate the purchase price or the discounted rate.
What to know about the time value of money?
The calculation of NVP focuses on an important aspect: the time value of money. It is critical to understand when evaluating the CRE property for investment. The time value of money holds money as quite valuable in the current time than tomorrow.
Essentially it will be the ability to renew the funds repeatedly to earn interest on it. Here is an example to help you understand better.
Will an investor be ready to give $1000 today or prefer to give $1000 5 years later?
The time value of money here states that the concept will make better sense today as he can reinvest with the hope that it will be worth more than $1000 in the coming five years.
The concept explains the future expectation of the cash flow that are all discounted back to the present time for determining the property’s appropriate value.
NPV vs IRR
Generally, investors need clarification on IRR and NVP. No doubt they can be very similar, but one needs to understand the difference between them.
For instance, on one side, the IRR helps measure the return one can expect on future investment for a specified period. On the other hand, like NVP, it will require the completion of Performa and proper estimation of the future cash flow series.
Also, in this case, the calculation can be quite complex. But it can quickly be done in a spreadsheet program.
You can expect to get the results of NVP in dollar figures, while the results of the IRR calculation will be in the percentage form of the annual return with each set of the cash flow gain. When NVP comes to zero, it will show that the discount will equal the IRR.
Net present value is an essential metric aspect that investors need to consider before investing. It will help them understand and measure the potential profitability they can expect from the transaction.
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