In the finance and real estate world, the term net present value (NPV) is used to help investors understand the value of money in an investment over time. If you're investing in cash flow real estate, learn what NPV is, how the net present value calculation works, and how the net present value method is used in real estate.
What is NPV?
Net present value is a formula that allows investors to determine the value of an investment today despite the investment earning income over time through residual cash flow. The NPV calculation takes into account all income, revenues, and expected cash inflow after expenses earned over the life of an investment with a discount rate that takes into account inherent risks of the investment as well as time. Ultimately, it helps investors compare different investments by looking at the present value of their money today, their initial investment, and comparing to the present value of their money in the future, the projected cash flow with the discount rate.
Why use NPV?
The value of money is constantly changing. Thanks to inflation, money today will always be more valuable than money in the future, meaning loans or other investments that provide a consistent or identical income stream over time can be difficult to calculate a value or return on. The NPV method reflects the value of money in the investment over time in today's value, where each future cash flow over the repayment period decreases in value slightly to reflect the cost of inflation and time.
What is the NPV calculation?
Luckily, for those who aren't well-versed in computing complex calculations without assistance from a calculator or spreadsheet, there are plenty of free calculators or tools online that will help you calculate the net present value of an investment opportunity. There is even an Excel NPV function that can quickly calculate the NPV of an investment directly in a spreadsheet, which is especially helpful for investments with uneven cash flow.
But for those who want to know how the NPV formula works, the NPV calculation is as follows: