Question

Assets are used to generate revenue and may incur some costs. Explain how the NPV method could be used to value assets, like a house for example.

Answer 1

The net present value of an investment property is a measurement that indicates the present value of all future cash flows produced by a rental property minus the initial cash investment required to buy the investment property.

Calculating the net present value: How it works

1- First, the real estate investor sets a rate of return that he or she desires to make from buying the investment property.

2- Second, using the net present value formula, all future cash flows are discounted to determine the present value of those future revenues. Keep in mind that the cash flow of the “nth” year or last year of holding the real estate investment property includes the sales proceeds of the property.

3- Finally, subtract the initial cash down payment from the total present value of future cash flows.

Example of calculating the net present value

Assume you are buying an investment property with an initial cash investment of $25,000 and your desired rate of return on the investment is 10%. The annual cash flows from holding the property for 3 years are equal to $5000, $4000, $6000, and sales proceeds equal to $150,000. Assume you still owe the bank $100,000. Thus, the cash proceeds from selling the investment property after 3 years would be $50,000.

C0= $25,000

C1= $5000

C2= $4000

C3= $6000 + $50,000 = $56,000

Discount future cash flows using npv formula:

DC1 = $4545

DC2= $3306

DC3= $42,074

NPV = $4545 + $3306 + $42,074 – $25,000= $24,925

NPV is greater than zero which means your desired rate of return is achieved.

Calculating the net present value is also used to compare different investment properties. When using the same npv formula to calculate the net present value of different investments, the one with the higher value will yield a higher return at the same discount rate.

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