Calculating Net Present Value For Rental Property
Net present value of future cash flows in real estate is one of the many calculations that one can make in order to differentiate between competing real estate investments. NPV of future cash flows is certainly not a calculation that can be done on the back of a napkin, but if you understand how it works, it will better equip you to use net present value software or for the more advanced finance minds, even an excel spreadsheet.
Net present value is really exactly what it sounds like. It is a calculation that calculates the present value of your NET future cash flows from real estate property investing. This is the first challenge with this calculation...the future must be estimated or projected. As with any calculation, the calculation is only as good as the data going into it. The present value of future cash flows can be projected as far into the future as you choose but our rental property calculator, is able to project NPV 30 years into the future.
Estimating Revenue and Expenses
How one chooses to make real estate projections is based on a person to person preference, but our rental property calculator simply makes these projection by assigning separate annual growth rates to revenue and expenses from your current rental income(revenue) and expenses.
Once one feels comfortable with revenue and expense projections for a self-determined number of years, these revenue and expenses projections must be used each year to calculate a net cash flow number from the property.
Calculating Real Estate Net Cash Flow
Net cash flow is not as simple as one might expect based on adding revenue and subtracting expenses. Some real estate expenses are more difficult to calculate than others. (such as estimated income taxes)
To calculate net cash flow, first calculate gross income by taking one month's rent times twelve, and then subtract any vacancy allowance you might expect. Vacancy allowance is just what it sounds like...it is a way to be conservative and adjust for possible problems finding people to rent to.
Next, you'll need to subtract estimated expenses from rent. There are many places expenses can come from but a few might include HOA fees, property taxes, property insurance, utilities, and repairs and maintenance. Projecting these is not always easy, but if you are able to find experts in each respective area, you might be able to get more accurate estimations. For example, talk to an insurance agent to get an estimate on property insurance. And property taxes can be easy to estimate by visiting the county tax assessor's office.
Once expenses are subtracted from gross rental income, this equals your EBITDA or earnings before interest, taxes, depreciation, and amortization. In order to calculate net cash flow, interest and taxes still need to be subtracted. Depreciation does not need to be subtracted because it is a "non-cash" expense. By "non-cash" expense, that means depreciation is an expense that is allowed by the IRS but doesn't cost actual money. However, depreciation will be needed to calculate income tax expense.
First, let's subtract the mortgage interest expense from EBITDA. Because mortgage interest is a pure expense that gets paid to the bank, this must be subtracted to arrive at net cash flow. A simple mortgage calculator should provide a breakdown of principal and interest in year 1 in order to make this much more simple.
Next, subtract depreciation expense. As was stated earlier, this isn't an actual cash expense, but it needs to be subtracted before property income taxes can be calculated. (After taxes are calculated, depreciation gets added back in) Once depreciation is subtracted, multiply the result by your estimated marginal tax rate. This result is an estimated property income tax in year 1. After subtracting the property tax expense from income, add depreciation back to your income.
This is almost the final net cash flow calculation but there is one more thing to factor in. That one thing is mortgage principal. Mortgage principal is not considered an expense since principal payments go towards a property's equity. And so it would seem unnatural to deduct principal payments from income and if this was a net income calculation, that would be true. But this is a "net cash flow" calculation and since principal is paid purely to equity(and not cash), it cannot be considered cash flow in the truest sense of the term. Therefore, it must be subtracted in order to calculate final net cash flow.
How does principal then get factored into the ROI calculation one may ask? The cash flow from mortgage principal payments will get factored in in the final cash flow which is the one where the investment property is sold. More on that later.
Net cash flow can be confusing so here is a formula version of the calculation with the bullet points representing steps in the process:
- Gross Income(including vacancy allowance) - Operating Expenses = EBITDA(Earnings before interest, taxes, depreciation and amortization)
- EBITDA - Interest Expenses - Depreciation = EBTA
- EBTA x Marginal Tax Rate = Estimated Property Income Taxes
- EBTA - Estimate Property Income Taxes = Net Income
- Net Income + Depreciation - Mortgage Principal Payments = Net Cash Flow
Similar to an NPV calculation itself, net cash flow can also be time intensive, especially if you are trying to create net cash flow projections over time such as is the case here. It's a good idea to let an investment property calculator do the work for you.
The First and The Last Cash Flow
No, that's not the title of a nerdy finance flick. That is a reminder that we need to consider both the first and the last cash flow in our NPV model. Specifically, this is referring to the purchase and the sale of the investment property. The purchase relates to the outflow of cash and this will include items such the down payment, brokerage fees, and/or renovation fees. The sale relates to the inflow of cash and could include items such as the proceeds from the sale net of mortgage debt and any brokerage fees paid to a realtor.
These are typically the two largest cash flows in the equation and as such, they can swing the needle significantly if they are miscalculated or left out altogether.
Calculating Present Value of Cash Flows
The formula for calculating the present value of cash flows is:
Present Value = CF0 + CF1 x (1 / (1 + R)1) + CF2 x (1 / (1 + R)2) + CF2 x (1 / (1 + R)3)..........
Where CF = Cash Flow and R = Chosen Discount Rate
Choosing a Discount Rate
The discount rate has not been discussed but it was mentioned in the formula above. For those who don't understand what the discount rate is, this is the rate chosen that will be the rate at which future cash flows will be discounted back to a present value. The larger the discount rate that is chosen, the smaller present value this will calculate.
Why should a certain discount rate be chosen? There are several methods to choosing a discount rate. The most common method is to choose the discount rate based on a certain rate of return that you demand to get on your investments. By choosing with this method, if the NPV calculated is positive, that indicates that the real estate investment in question, will return the equivalent of the discount rate chosen...or greater. As was mentioned earlier, this is completely contingent on estimates and projections being accurate.
In order to compare different rental property investments, use the same discount rate in comparable projections and the projection with the largest calculated NPV is the better investment....based on estimates and projections.
Net present value of net future cash flows was something that was more commonly used in the past until computer technology made the internal rate of return calculation more viable.
Using NPV's Cousin - Internal Rate of Return
The internal rate of return is directly related to net present value. How is that? Internal Rate of Return, or IRR for short, is that rate of return where NPV of future cash flows equals zero. See IQ Calculators' article on calculating return on investment for rental properties for more details on how IRR is calculated and why it should be used.
For purposes of this article, just know that IRR is a complex calculation outside of using computer technology....whether that be a financial calculator, an excel spreadsheet, or our real estate investment calculator.
Net Present Value of future net cash flows for real estate is simply calculated by using a time value of money calculation to discount net cash flows to a present value number or "Net Present Value." This is not a back of the napkin calculation and should be done using an investment property calculator. What makes this calculation challenging is projecting and estimating annual revenue and expenses in order to calculate a net cash flow result a number of years into the future. This will test any person's ability to predict the future and using conservative estimates is one way to guard against unforeseen future events.