Real Estate Investment Alphabet – Part I

by Frank Gallinelli on

It may seem like a witch’s brew of random letters – but truly, it’s just real estate investing. You can handle it. Any or all of these measures can be useful to you, if you understand what they mean and when to use them.

NPV (Net Present Value)

NPV is, of course, Net Present Value. NPV is connected to what all good real estate investors and appraisers do, namely discounted cash flow analysis (aka DCF, if you’d like some more initials). Discounted cash flow is a pretty straightforward undertaking. You project the cash flows that you think your investment property will achieve over the next 5, 10, even 20 years.

NPV is a method to pause and ponder the future value of an investment made with today’s dollars

Then you pause and remind yourself that money received in the future is less valuable than money received in the present. So, you discount each of those future cash flows by a rate equal to the “opportunity cost” your capital investment. The opportunity cost is the rate you might have earned on your money if you didn’t spend it to buy this particular property. Now you have the Present Value of all the future cash flows. 

What does that mean to you as an investor? If the NPV is positive, it suggests that the investment may be a good one. That’s because a positive NPV means the property’s rate of return is greater than the rate you identified as your opportunity cost. The more positive it is in relation to the initial investment, the more inclined you’ll be to accept this investment. Our result here is not stellar, but it is at least positive.

If the NPV is negative, the property returns at a rate that is less than your opportunity cost, so you should reject this investment and put your money elsewhere.

Clearly, the NPV here is very sensitive to changes in the discount rate. If you revise your thinking just slightly about the appropriate discount rate, then the conclusion you draw may likewise need to be revised. As little as a half-point difference could change your attitude from luke-warm to hot or cold. The prudent investor will test a range of reasonable discount rates to get a sense of the range of possible results.

While we’re beating up on NPV, let’s also note that it doesn’t do you much good if your goal is to compare alternative investments. To have some kind of meaningful comparison, you need at least to keep the holding period for both properties the same. But what if one property requires that $300,000 cash investment, but the alternative investment requires $400,000? Fortunately, NPV has a cousin that can help you with that problem: Profitability Index.

Profitability Index

While the NPV is the difference between the Present Value of future cash flows and the amount you invested to acquire them, Profitability Index is the ratio. It doesn’t tell you the number of dollars; it tells you how big the return is in proportion to the investment.

A Profitability Index of exactly 1.00 means the same as an NPV of zero.

You’re looking at two identical amounts, in one case divided by each other so they give a result of 1.00 and in the other case subtracted one from the other, equaling zero.

An Index greater than 1.00 is a good thing, the investment is expected to be profitable; an Index less than 1.00 is a loser. When you compare two investments, you expect the one with the greater Index to show the greater profit.

But Wait…

This sounds terrific; we’ve found the perfect way to measure our investment’s return. But wait – IRR has a few warts. Sometimes its results are imperfect, sometimes even misleading.  In Part II, we will look at the problems with IRR and at some potential solutions. We’ll examine Modified IRR and Capital Accumulation Comparison (CpA), and how they might provide us with a means of dealing with the shortcomings.

Click this link to Read Part II:  http://multifamilyinsight.net/2012/06/18/real-estate-investment-alphabet-part-ii/

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Reprinted with permission of RealData — software for real estate investors and developers — www.realdata.com

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