Find out why commercial real estate brokers need to know and calculate NPV for their clients.
NPV | What’s the Value of Net Present Value in CRE?
Inflation Definition: Inflation refers to the increase in prices of commodities over a period of time. It has the potential to devalue a currency or living standards.
What Is Net Present Value?
What is NPV? Net present value, or NPV, is a complex equation used to analyze how profitable a potential project or investment is likely to be.
It compares the worth of a dollar today with the value of the same amount in the future, taking factors like inflation and returns into account.
In other words, it is the formula that lets investors know if a project is worth investing in. You can see the net present value formula here.
You can then break down the elements into the following:
- C = cash flows
- n = number of periods
- N = the holding period
- r = discount rate
NPV’s principle is it equals the present value minus the cost. It may sound complex, but learning how to calculate net present value is vital.
No one wants to pay more for an investment than it is worth. An excellent commercial real estate broker can help an investor make a sound decision by calculating net present value.
It may even encourage them to invest more money if the client believes they can earn more for every dollar.
RELATED: 4 Basic CRE Financial Metrics You Need to Know
What Is the NPV Rule?
The rule is simple: invest when the numbers are positive. Hold or let go of an investment if they are negative or down.
Despite the simplicity, many misunderstand it. It even happens to people who work in industries like real estate and finance.
Once you understand the net present value and how it works, the better you can predict the worth of a potential project, particularly to the company, client, or portfolio.
What Are the NPV Categories?
An investment can fall into any of these net present value categories:
- Positive NPV: It indicates a positive return. It may also mean you are paying less for the investment than it’s worth.
- Negative NPV: It implies a negative value for the investment. You may also be paying more than it is worth.
- Zero NPV: It suggests a neutral value for the investment. You may be paying its precise worth.
Why Is Net Present Value So Important?
Your money today can have a far lesser value in, say, the next five years. That is the direct result of inflation.
When it comes to investments, it means one dollar earned in the future is less than $1 you get today. The NPV formula accounts for this with the discount rate.
It helps investors determine whether a commercial real estate is worth the money and the wait. It may also direct them to other CRE investments with a higher return within the same timeframe.
The rate of return one investor considers acceptable and worthwhile doesn’t need to match personal goals and interests.
The key is to know the rate of return they’re willing to accept from an investment. It also takes into account their investment timeframe or how long they’re willing to wait to get it.
Then they can find an investment opportunity with sufficient NPV to help meet their goals. You and the client can use the formula above to determine the net present value for various investments.
Know, though, it’s even easier with an NPV calculator that does all the work for you. Either way, it is always wise to consider NPV while contemplating investments.
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