What is NPV and How Does It Work?

NPV is yet another tool in the box of calculations that can be used to assess commercial real estate investments and other investments.

Many metrics used in investment assessment are static and insensitive to various real-world investment conditions. For example, cash-on-cash return, ROI, or cap rate, do not typically factor in the changing value of money over time. They can provide quick summaries of how an investment might perform over a short space of time, e.g. a year, but fail when longer-term investments are concerned where values tend to fluctuate with inflation and other factors.

NPV, on the other hand, takes future cash flows and discounts these back to the present day so they can be assessed and compared with other investment options over the same period. NPV calculates the sum value of future cash flows in present day terms.
 

Why NPV Matters

Money in the present is typically worth more than the same quantity of money in the future. This is due to both inflation and also the potential profit that can be made on that money during a given timeframe.

Say an investor is offered £100 today, or is given the option to receive that £100 in a year’s time. Indeed, the rational option would be to take that £100 now. Not only is it worth more now, as it will be worth less in a year’s time due to inflation, but it can also be invested immediately, thus yielding the chance to generate more money from that £100.

However, say the investor is offered £100 now or £105 in a year’s time – this is a lot harder to assess. £105 in a year’s time is likely worth more than £100 now, even when accounting for inflation. But, this also means there is no opportunity to invest that money immediately. If the investor can use the £100 to generate more than 5% on it in a year, that £105 in a year’s time still has a lower value than £100 now.

If you’ll get £105 in a year’s time by simply taking the £100 and putting it in a saving’s account, then you will want to compare this to other investment options to see if they’re worth it. This is just one way in which NPV can be used.
 

Calculating NPV

This is the formula for NPV. The net present value is the sum of cash flows (C), over each period (n) during the holding period (N). This is discounted by the discount rate or return of other investments (r).

A simpler way to visualise this formula is as follows:

NPV = TVECF – TVIC

TVECF is ‘Today’s Value of the Expected Cash Flows.’

TVIC is ‘Today’s Value of Invested Cash.’

A further simplification of this would be to consider NPV as present value minus cost over time. The costs here simply factor in the time value aspect of money, such as inflation, whilst discounting that with the potential to earn through other investment opportunities. After all, inflation is a cost as it costs you value on your investment over time.

If we revert to our £100 example, then this investor would have to consider the costs of investing this £100 to make more than £105 in the future. When factoring in costs and inflation, accepting £105 in the future rather than £100 now could be either good or bad.
 

The Time Value Aspect of Money

Value is time-sensitive. If we boil the time-value aspect of money down to two basic principles, these are:

  • More is better than less
  • Sooner is better than later

The first statement is obvious, but it is also conditional on the second. More is better than less right now, but when we factor in time, this is not necessarily true.

If we make a large-scale property investment now, its value will certainly change over time. Whilst we might expect the value of that building to rise, it is still subject to inflation, and that much is for certain. Simultaneous to this, there is an opportunity for compounding the building’s rise in value to add more value exponentially. Some of these factors can be forecast reliably, but others cannot. NPV is designed to at least provide an estimate, based on forecasts, that can aid investors in assessing the long-term viability of an investment project.
 

NPV in Action

Take a commercial building that costs £1,000,000. It can provide £25,000 of manufacturing revenue a month year for 5 years.
 

Calculating the NPV of Initial Investments

The building will be paid for upfront, and thus this is the first cash flow of the investment. This is made in the present day, and reflects the present-day value of this money. It does not need to be discounted.
 

The NPV of Future Cash Flows

We know that the investment provides £25,000 a month over 5 years, but this £25,000 will decline in value over time. We will have to discount £25,000 against the rate of inflation to discover how the value of this will decline. There are 60 total cash flows here (12 months x 5 years).

All 60 cash flows will need to be compiled and discounted by both inflation and the discount rate. The discount rate is commonly used as the expected rate of return.

Consider that there is an alternative investment available for an expected return of 8%. The risks are thought to be roughly the same. This reverts to our previous analogy – we require a present value greater than the future value of our money in order to make the investment worthwhile. We would therefore discount this future cash flows by the value of alternative potential investments.

If you get an annual return of 5% by simply sticking the cash into some stocks or shares, then you’ll be expecting a return greater than this to make the investment worthwhile. This is why you discount the value of the cash flows by that expected rate of return (which will be greater than 5%).

Essentially, you’re factoring in that there are other investment opportunities out there – you aren’t simply comparing this investment to letting the cash sit there collecting dust.

Calculating the discount rate can be a little trickier when comparing cash flows to the yearly rates of return available from other investments (e.g. interest). Here, we need to take the alternative investment’s annual figure of 8% and identify the periodic monthly discount rate to use in the equation.

Period Rate = ((1+0.08) 1/12) – 1 = 0.64%. This would be inserted into r.
 

Results

There are 3 possible results from an NPV calculation.

Positive: Positive NPV essentially means the costs of the investment now are less than its worth in the long term.

Negative: The opposite is true, and despite perceived profits, your earnings on this investment are below its value.

Zero: You neither make nor lose value.
 

Pros and Cons of NPV

NPV, despite accommodating some more complex factors compared to other real estate metrics, still draws on many assumptions. Namely, it estimates the costs of investments, the discount rate itself, and the value of any projected returns. Unforeseen costs can sabotage NPV calculations pretty easily.

Furthermore, whilst NPV comes into its own for larger value investments that progress over several years, it would be unnecessary to use for shorter-term investments.

As always, there are numerous other factors that can complicate the calculation, such as the value of assets at the end of the investment period, the potential for compounding, and much more.

NPV is designed to offer a way of comparing and contrasting the value of an investment, discounted for the time-value aspect of money, and compared to similar alternative investments.

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