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Determining Net Present Value (NPV) - Real Estate Investment Tips

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Published on Aug 27, 2013

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As I discussed in my "Investing Terms Part 2" video, Net Present Value -- or NPV -- means to convert all the future cash flows into today's dollars. Which even for me is still a bit of a confusing way to understand it. For a quick recap on how we calculate this figure, let's look at a simple example.

If you buy a property for $1m, and make $100k/year every year for 5 years, then SELL the property for $1m again at the end of the 5th year, your internal rate of return will be 10%. To explain this simply, you've made 10% on your money every year for the last 5 years since you bought and sold the property with no profit. But what is your Net Present Value? Well, you're NPV can only be determined by you as an investor.

As an investor, you need to have an idea of what kind of return you are ok with making. For example, if you place your money in a savings account, you know that tomorrow, next year and even in 10 years your money is going to be there. Even if the bank closes, so long as you have under $250,000 in your account the federal government will guarantee that your money is safe. Because of the safety factor the bank in return pays you a very, very small return rate. Usually half or a quarter of a percent. Because of the lack of risk and the extreme safety of your money, you're NPV is under 1%. Safety is your goal. If you willing to go into a decaying market where unemployment is extremely high and the populating is shrinking, you may be demanding a higher NPV. If you're looking into investing in a strong market where there is low unemployment and the population is growing, you may demand a lower NPV.

Let's look at a real life example in my market area. San Francisco is currently -- and almost always -- considered one of the top investment locations in the US along with New York, LA and other large metro areas. Because many people view it as a stable investment, they're willing to accept less of a return, typically in the 3-6% range. Right outside of San Francisco are some pretty stable locations which aren't considered as great as San Francisco but are fairly close to investment value. In locations such as Berkeley and Downtown Oakland your average return range may be 5-9%. Once you start venturing out further and further away from the main business hub the rates start to increase depending on a variety of factors. For example, if you take a location with a higher than normal crime rate and higher unemployment you will likely see return rates of over 15%. However, if you take another location that is the same distance from San Francisco but is a high income area with low unemployment you will likely see return rates in the range of 8-12%. If you go to a city where there is only one major employer who is about to go bankrupt and could very likely close their factory doors, then return rates would be much much higher than 15% due to the extreme risk.

Which again brings us to the point of you as an investor knowing what your desired return rate is. Let's go back to the same $1m property example. Let's say you are interested in the particular property, but because you think some tenants might leave you don't want to make 10%, you instead demand 12%. Using the same $1M property example above, if you plan on selling this property in 5 years for the same $1m you purchased it for, you would have to pay $72,000 LESS than $1m to attain your 12% Internal rate of return. But presume there's a bidding war, and you feel this property is under priced just to draw in your offer. Instead of 10%, you're perfectly comfortable with 8%. Again you using our example you could pay about $80,000 MORE than the $1m list price and still make your 8% return rate.

Determining your NPV isn't the easiest thing in the world. Nor is it the easiest concept to understand. However, don't confuse the fact that it is a bit tricky to understand with the fact that it is one of the most sought after methods by investors in determining what a property is worth to them...now that's good to know.

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