Net Present Value: Accept or Reject?

photo credit: vivalars

This is a beginner’s guide to Commercial Real Estate Analysis, so let’s cut the technical fat and get straight to the point.

Recall the following posts:

Time Value of Money – If you were offered ‘$100 in the future’ or ‘$100 today’, you would prefer the money today.  Why? Because at that specified moment in the future, the offer would be ‘$100’ or ‘$100 and all the money earned’.  Simply, we want money today and all its Potential Earning Power (don’t forget about inflation!).

Why this helps: we know money in the future is worth less than money today.

Present Value -Present Value is the current worth of a future sum given a specified discount rate.

Why this helps: present value can be applied to multiple cash flows!

And just like that we arrive at Net Present Value: the sum of *all* discounted future values (note: cash flows are often projected or assumed).

Commercial Real Estate typically requires an initial investment (or negative input) included at time zero of the calculation (often a down payment, or purchase price). I’m a very visual person, if you find any of this confusing, spend a few moments with the following graph and you’ll find yourself back on track!

As you can see, Cash Flows are projected with an assumed discount rate (10%, 15%, and 20% scenarios above!) which forces each individual cash flow to a present value, and sums in the right hand column to a NPV for the entire investment.

NPV is an indicator of how much value an investment adds. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected and generally speaking the following is true:

  • If the NPV of an investment is greater than zero, accept!
  • If the NPV of an investment is less than zero, reject!

Simple as that! A positive Net Present Value says that by investing, you’ll have more theoretical money in your wallet TODAY than you would by not investing. Of course, that acceptance assumes no risk and limitless funds, but remember you’re probably tying up your money, and future cash flow isn’t always certain (but that’s what you’re being paid for!). So most of the time, you have to be picky.

We’ve put together a great excel tool to visualize the variables involved in Net Present Value (click!), and of course, it’s free.

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