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Net Present Value (NPV) (Discounted Cash Flow Measure) article

NPV is the foundation of the discounted cash flow (DCF) process. With NPV you assume a discount rate (defined here as the yield you would like to get). The NPV is the amount you need to adjust the beginning amount (ie the purchase price) by so that the investment cash flows will give you that yield. The nature of the NPV is that it takes everything into account that made up the cash flow. The only weakness is that it is hard to calculate (not with planEASe, of course), and that it uses all the assumptions (which is where Sensitivity Analysis becomes incredibly useful).

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Video Title: Learn about the Net Present Value (NPV) (Discounted Cash Flow Measure)

Video Publication_Date: Saturday, December 24, 2016

Video Duration: 9:00

Video Description:
Shows how the Net Present Value (NPV) is calculated, what factors are important, and how to use planEASe Sensitivity Analysis to find which assumptions affect the Net Present Value (NPV) most. The idea of the Net Present Value (NPV) is very important to commercial real estate investing.

201020112012201320142015
IRR Before Debt1.5%9.0%9.9%9.0%9.5%8.0%
IRR Before Tax9.2%12.1%9.5%11.0%7.0%
IRR After Tax6.5%8.8%6.6%7.8%4.6%
NPV Before Debt @10.00%($246,299)($54,097)($8,769)($106,089)($66,107)($273,216)
NPV Before Tax @10.00%($236,599)($16,136)$56,761($17,540)$42,716($146,603)
NPV After Tax @10.00%($233,929)($68,875)($32,053)($121,655)($95,859)($265,158)


Determining what Discount Rate to use
A major difficulty with using Net Present Values in order to make investment decisions is determining what discount rate to use in the calculations. Theoretically, the proper discount rate is the rate at which alternative investments may be made. Thus, if a savings account is the investor’s alternative, the six percent discount rate currently offered by the bank may be appropriate. Other investors may feel that they have different alternatives, however. For this reason, the individual investor’s discount rate is an assumption in the analysis so that it may be varied for each investor. This difficulty in determining the proper discount rate is eliminated, however, when the investor uses the Internal Rate of Return to evaluate the investment.
Monthly Calculations
In the world of commercial real estate, cash flows occur monthly and the dollar amounts of the revenue and expense cash flows are almost always irregular. In the past there were mathematical games that were played to get the Net Present Value to reflect the monthly irregular cash flow, and you might still hear some of the old ways spoken of today, like "beginning or end of period" or "mid year convention" (Monthly vs Yearly IRR Discounted Cash Flow Measure Comparison). These tricks were necessary in a world where you typed individual cash flows into a calculator or spreadsheet. However, in the modern computing world there is no need for these mathematical tricks, because computers are now fast enough to handle the present value discounting process on a monthly basis. The initial process for computing NPV in Excel and other spreadsheets made the assumption that the cash flows occurred annually and at the end of the year. With the new speed of computers, it became feasible to compute NPV more accurately by including the date of the cash flow as well as the amount. This new (and much more accurate) method of computation is known within Excel (and other spreadsheets) as the XNPV function. Here are links to descriptions of the XNPV process:
XNPV Verification
If you are interested how to verify the monthly NPV look to this page Verify Monthly IRR and NPV Using Excel or Google Spreadsheets XIRR and XNPV. Also there is a "Net Present Value Report" shown at the end of this article that has all the monthly information to use for the verification. The NPV's shown in the proforma examples will be very slightly different than the true XNPV process show in the planEASe Cash Flow Utility, Excel XNPV, and Google Spreadsheet XNPV because the NPV's shown in the Proforma Samples do not use leap years, so in a six years analysis there can be 1 or 2 days difference in time length.
Net Present Value NPV Considers:
  • All assumptions entered such as: Scheduled Income, Purchase Price, Down Payment, Current Debt Payment, Vacancies, Expenses, Property Taxes, Lease terms, Revenue Growth, Rent Control, Expense Growth, Property Tax Growth, Deferred Maintenance, Debt Amount (Ratio), Interest Rate, Interest Rate Changes, Payment Changes, Points, Prepayment Penalties, Depreciation, Capital Expenditures, Income Taxes, $25,000 Exemption, Passive Losses, Appreciation, Capital Gains Tax ... and all other entered assumptions
Net Present Value NPV Ignores:
  • Only assumptions not entered

Why is Net Present Value NPV useful?
NPV is the foundation of the discounted cash flow (DCF) process. With NPV you enter a discount rate which is the yield you would like to get. The NPV is the amount you need to adjust the beginning amount (ie purchase) by to equal that yield. The nature of the NPV is that it takes everything into account that made up the cash flow. The only weakness is that it is hard to calculate (not with planEASe of course), and that it uses all the assumption values (so, in turn, you are required to enter these assumptions, which means more work on your part).
The Net Present Value NPV is shown in these planEASe reports:
Net Present Value Report
Retail - Office

These cash flows and dates are those on which the Net Present Value Before Tax in the planEASe analysis of the Retail - Office are based.

planEASe Software plans operating cash flows monthly, and assumes that cash flows occuring during the month all occur at the middle of the month.Calculators and Spreadsheets typically schedule these cash flows at the end of the year (year-end convention).Since cash flows do actually occur unevenly during the year, the mid-month convention is more accurate.

The Net Present Value (NPV) of the Cash Flows shown in the table below, when discounted at 10.0000% to 1 Jan 2010 is ($146,597.42). One interpretation of this NPV is that you must pay $146,597.42 less on 1 Jan 2010 for the right to receive the cash flows shown, if you want a 10.0000% Internal Rate of Return on your total investment.



Date

Years

Cash Flow
Present Value
Discount Factor
Present Value
at 10.0000%
1 Jan 20100.00($1,023,343.86)1.0000000($1,023,343.86)
16 Jan 20100.042,236.820.99609082,228.08
15 Feb 20100.122,236.820.98831822,210.69
18 Mar 20100.212,236.820.98035022,192.87
17 Apr 20100.292,236.820.97270042,175.76
17 May 20100.372,236.820.96511032,158.78
17 Jun 20100.462,236.820.95732952,141.37
17 Jul 20100.54(9,710.70)0.9498593(9,223.80)
17 Aug 20100.625,457.260.94220145,141.84
16 Sep 20100.715,457.260.93484935,101.72
17 Oct 20100.795,457.260.92731245,060.58
16 Nov 20100.875,457.260.92007655,021.10
17 Dec 20100.965,457.260.91265874,980.62
16 Jan 20111.045,780.600.90553715,234.55
15 Feb 20111.125,780.600.89847115,193.70
18 Mar 20111.215,780.600.89122755,151.83
17 Apr 20111.295,780.600.88427315,111.63
18 May 20111.385,780.600.87714405,070.42
17 Jun 20111.465,780.600.87029955,030.85
18 Jul 20111.545,861.790.86328305,060.38
17 Aug 20111.625,861.790.85654675,020.90
16 Sep 20111.715,861.790.84986304,981.72
17 Oct 20111.795,861.790.84301134,941.56
16 Nov 20111.872,917.390.83643322,440.20
17 Dec 20111.963,015.140.82968972,501.63
16 Jan 20122.04(6,618.04)0.8232155(5,448.07)
16 Feb 20122.13(107,129.28)0.8165786(87,479.48)
17 Mar 20122.215,169.260.81020684,188.17
17 Apr 20122.295,169.260.80367484,154.40
17 May 20122.385,169.260.79740364,121.99
16 Jun 20122.465,169.260.79118144,089.82
17 Jul 20122.545,419.560.78480274,253.29
16 Aug 20122.625,419.560.77867884,220.10
16 Sep 20122.715,419.560.77240104,186.07
16 Oct 20122.795,419.560.76637394,153.41
16 Nov 20122.885,419.560.76019534,119.92
16 Dec 20122.965,499.990.75426344,148.44
15 Jan 20133.045,524.260.74837784,134.23
15 Feb 20133.135,877.880.74234424,363.41
17 Mar 20133.215,877.880.73655164,329.36
17 Apr 20133.295,877.880.73061344,294.46
17 May 20133.385,877.880.72491244,260.95
17 Jun 20133.465,877.880.71906804,226.60
17 Jul 20133.54797.320.7134570568.85
17 Aug 20133.63954.150.7077050675.26
16 Sep 20133.715,856.270.70218274,112.17
16 Oct 20133.795,856.270.69670354,080.08
16 Nov 20133.885,856.270.69108664,047.19
16 Dec 20133.965,939.120.68569404,072.42
16 Jan 20144.045,963.880.68016584,056.43
15 Feb 20144.136,328.110.67485844,270.58
18 Mar 20144.216,328.110.66941764,236.15
17 Apr 20144.296,328.110.66419404,203.09
17 May 20144.386,328.110.65901124,170.30
17 Jun 20144.466,328.110.65369824,136.67
17 Jul 20144.546,328.110.64859734,104.40
17 Aug 20144.636,454.840.64336824,152.84
16 Sep 20144.716,454.840.63834794,120.43
17 Oct 20144.796,454.840.63320154,087.21
16 Nov 20144.886,454.840.62826054,055.32
17 Dec 20144.963,039.440.62319541,894.17
16 Jan 20155.04(7,757.88)0.6183325(4,796.95)
15 Feb 20155.13(3,974.88)0.6135076(2,438.62)
18 Mar 20155.21(3,974.88)0.6085614(2,418.96)
17 Apr 20155.29(3,974.88)0.6038128(2,400.08)
18 May 20155.38(75,114.05)0.5989447(44,989.16)
17 Jun 20155.468,703.630.59427115,172.32
18 Jul 20155.558,703.630.58948005,130.62
17 Aug 20155.638,834.170.58488025,166.93
16 Sep 20155.718,834.170.58031635,126.61
17 Oct 20155.798,834.170.57563775,085.28
16 Nov 20155.888,834.170.57114595,045.60
17 Dec 20155.968,834.170.56654135,004.92
31 Dec 20156.001,370,777.840.5644739773,768.35
TOTALS$481,767.24($146,597.42)



Written by
Michael Feakins, CCIM
of planEASe Software