Investing in commercial real estate can be a great opportunity to build wealth.
As with all investments, profit potential is a major consideration when comparing different properties. How can you be sure that the money you invest today will generate healthy profits in the future?
This is where net present value and internal rate of return come in. These measures estimate whether a potential investment will generate a profit or a loss. They also take into account the present value of the investment in today's dollars.
Net present value (NPV) is the difference between the present value of expected cash inflows and the present value of expected cash outflows over a given period of time. Expressed as a dollar amount. Internal rate of return (IRR) is the estimated annual growth rate. Expressed as a percentage.
Let's take a closer look at how to use these metrics when evaluating and comparing commercial real estate opportunities.
Net Present Value
Net present value considers all expected cash flows over the life of the investment.
NPV equals the difference between cash inflows and cash outflows. An NPV greater than zero usually indicates a profitable investment. A negative NPV means the investment is likely to decrease in value.
Factors to consider when estimating NPV include expected inflation rate and reinvestment rate.
How to calculate net present value
To determine the NPV, follow these steps:
You estimate the present value using a discount rate to estimate the expected cash flows. Subtract the estimated cash flows from the initial cash outlay. The difference is the net present value of the investment.
With many investments, cash flows vary over time – for example, some years' inflows may be larger than others.
Analysts use the following formula to estimate the timing and amount of expected cash flows over the investment's life:
Current formula for net worth:
Ct = Net cash inflow during period t
C0 = Total initial investment cost
i = discount rate
t = number of periods
Analysts use a discount rate equal to the minimum acceptable rate of return, based on the principle that a dollar today is worth more than a dollar tomorrow because inflation makes money worth less over time. Typically, a positive NPV indicates that the rate of return is likely to be higher than the discount rate.
Internal rate of return
The Internal Rate of Return helps you make a fair comparison between multiple investments. It can be useful if you are considering multiple commercial properties. The IRR estimates the annual growth rate that a property is expected to generate. The higher the number, the greater the potential return.
One common question is the difference between IRR and Return on Investment (ROI). The main difference is that ROI calculates the percentage increase or decrease in value of the overall investment, while IRR takes into account the fluctuations in cash flows over discrete periods and the present value of future dollars.
How to calculate the internal rate of return
Mathematically, the IRR is the discount rate at which the net present value of the cash flows equals the initial investment.
To determine the IRR, follow these steps:
Apply the same formula as for calculating net present value. Set NPV to zero. Find the discount rate.
If the IRR is greater than the expected discount rate, the investment is more likely to be profitable. If the IRR is less than the discount rate, the property is less likely to be profitable.
Special considerations for using NPV and IRR
While NPV and IRR provide useful information in valuing commercial real estate, there are some caveats to keep in mind.
First, future cash flows are difficult to forecast. As we have all seen in recent years, market conditions can change in response to unexpected events. Many analysts will calculate multiple estimates that reflect a range of scenarios, from conservative to optimistic.
The rate of return on most investments varies from year to year, even during periods of relatively stable markets. The actual performance of commercial real estate can be expected to differ somewhat from the calculated NPV and IRR.
When making any investment decision, it is always important to consider multiple factors, such as the initial cost, the investment horizon, etc. You also need to consider how much risk and time commitment you are willing to take on.
Most analysts use specialized software to calculate NPV and IRR, so there is no need to calculate the equations manually.
Choosing an experienced commercial real estate broker can help you sort through all the information you need to make a smart investment decision. With over 60 years of combined experience, Commercial One Brokers has the in-depth knowledge to provide you with the best possible service.
Contact us today to learn more about the exciting opportunities available in the Branson, Missouri area.