Net Present Value: Definition, Calculation, and Application in Real Estate Sector

Net present value (NPV) is a method used for determining the profit by subtracting the present value of cash outflows including the initial investment from the present value of cash inflows within a specific period of time. This article explains how NPV is applied in the real estate sector for investment decision-making.

Net present value
Net present value is a method used for determining the profit by subtracting the present value of
cash outflows including the initial investment from the present value of cash inflows within a
specific period of time. It is the one of the renowned technique of capital budgeting analysis1. It
is applied by management for evaluating its investment to determine whether the return
generated from a given project is adequate profit or not. Thus, it helps the individuals for taking
the major decision by forecasting the profit from the project. Time value of money concept plays
a significant role in investment decision as after applying this method time effect of cash flows is
included. It is the very simple method for analysing the benefits of the project2. Positive NPV
indicates the profit generated by the project; therefore management will choose that project
which has positive NPV.
Calculation of net present value for real state options
Investment decision in real estate sector can be taken by applying the NPV method. Different
real estate opportunities can be evaluated by investors by analyzing the future cash flows as if the
present value of future cash flow expected to be generated from the rental income is higher than
the amount of investment in the property the investor is likely to invest in that property3. The
present value of future cash flows is calculated by the rate of return which is the investor’s
desired rate of return on investment, by using this rate investor get to know whether the target
rate of return will be achieved or not. If the present value of the future benefit is less than the
cost of those benefits, then the investor should go for the other investment opportunities.
Therefore it is the important tool for investors to evaluate the investment opportunities and invest
the money in the best project which will give the higher profit.
Computation of NPV to determine the maximum value to be provided for the purpose of
purchase of land:
Semester Inflows/outflows PV Present value of inflow or outflow
1 McCarthy, Scott. "Magic Timber and Steel: Investment Evaluation with Net Present Value." (2016).
2 Jagannathan, Ravi, et al. "Search in." CFA Digest 47.4 (2017).
3 Turvey, Ralph. The economics of real property: an analysis of property values and patterns of use. Routledge,
2017.

factor
10%4
1 -5000 0.9091 -4545.45
2 -5000 0.8264 -4132.23
3 -5000 0.7513 -3756.57
4 -5000 0.6830 -3415.07
5 10000 0.6209 6209.213
6 10000 0.5645 5644.739
100000
(Last year revenue’s infinity value)
10000/1.10
0.5645 56447
100000
(Land option value)
-56447
Net present value -3995.37
Therefore maximum value to be paid for the purchase of land should be near to the -3995.37 so
suitable option for the selection is option, i.e. 5000.
Assumptions
 As inflow are after tax, so it has been assumed that outflows are provided after tax as well
 Cost of capital, i.e. discounting rate has been assumed 10%
 Consideration of Land option value and Last year revenue’s infinity value has been taken
in computation, but the effect of the same nullifies due to a similar amount.
4 By considering inflation and real estate rates

REFERENCES
Jagannathan, Ravi, et al. "Search in." CFA Digest 47.4 (2017).
McCarthy, Scott. "Magic Timber and Steel: Investment Evaluation with Net Present Value."
(2016).
Turvey, Ralph. The economics of real property: an analysis of property values and patterns of
use. Routledge, 2017.