# Stirring the Alphabet Soup of Real Estate Investing, Part 1

UPDATE: I’ve re-written this multi-part blog post and it’s now available in a convenient “flip book,” readable in your browser:

5 Metrics Every Real Estate Investor Needs to Know

PV, NPV, DCF, PI, IRR–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, or Net Present Value, 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. Then you pause to 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” of 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.

Consider this example, where you invest \$300,000 in cash to earn the
following cash flows:

 Year 1 Cash Flow: 10,000 Year 2 Cash Flow: 20,000 Year 3 Cash Flow: 25,000 Year 4 Cash Flow: 30,000 Year 5 Cash Flow: 385,000 (includes the proceeds of sale)

If you discount each of these cash flows at 10%, then add up their discounted values, you’ll get 303,948:

 Year 1, Discounted: 9,091 Year 1, Discounted: 16,529 Year 1, Discounted: 18,783 Year 1, Discounted: 20,490 Year 1, Discounted: 239,055 Total PV of Cash Flows: 303,948

Now you have the Present Value of all the future cash flows. However, you also had a cash flow when you initially purchased the property (call that Day 1 or Year 0) – a cash outflow of \$300,000, your initial investment. To get the Net Present Value, you find the difference between the discounted value of the future cash flows (303,948) and what you paid to get those cash flows (300,000).

 NPV = PV of future Cash Flows less Initial Investment NPV = 303,948 – 300,000 = 3,948

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 look favorably on this investment. Your 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 probably reject this investment and put your money elsewhere.

That’s all fine, to the extent that you’re confident about that discount rate, your opportunity rate. You estimated 10% in the example above. What if you adjust that estimate by one-half of one percent either way?

 NPV @ 9.5% = 10,284 NPV @ 10.0% = 3,948 NPV @ 10.5% = (2,244)

 NPV @ 9.0% = 16,789 NPV @ 10.0% = 3,948 NPV @ 11.0% = (8,238)

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?

PI – Profitability Index

Fortunately, NPV has a cousin that can help you with that problem: 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 size of the  investment.

So where the NPV in the example above was equal to 303,948 minus 300,000, the Profitability Index looks like this:

 PI = 303,948 / 300,000 = 1.013

If, quite improbably, you expected exactly the same cash flows from the property that required a 400,000 investment, you would expect your Profitability Index to be much worse, and it is.

 PI = 303,948 /400,000: = 0.760

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.

Learn more about real estate investing metrics in my free flipbook, 5 Metrics Every Real Estate Investor Needs to Know

—Frank Gallinelli

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## One comment on “Stirring the Alphabet Soup of Real Estate Investing, Part 1”

1. Dr Kannan Arjunan on