Investing Series: How to Evaluate a Real Estate Investment Opportunity (Part 1)
If you’re looking for a real estate investment opportunities, you need to know about some basic tools that can help you analyze an investment’s potential to produce a good return and generate consistent cash flow. Familiarizing yourself with basic financial metrics, including net present value, internal rate of return, and cap rates, will allow you to evaluate potential investments’ performance.
Net Present Value (NPV)
To get an accurate estimate of the value of your investment opportunity, the NPV formula helps you subtract the present value of the money you invest from the present value of your cash inflows, taking into account that the value of money declines over time. In simpler terms, it allows you to figure out the current value of the money you expect to earn over a specified period of years, so you can see whether the value of those future earnings will exceed the current value of the money you invest. You can calculate NPV using varying assumptions for the change in value or discount rate.
You can find the NPV formula and more information about NPV on the Investopedia website. You can also calculate NPV using Microsoft Excel. NPV is a helpful guide and can help you compare multiple investment opportunities’ potential profitability. But it is not a perfect measure of the value of your investment, so be sure to look at other metrics. The timing of cash inflows and outflows can also influence the NPV calculation.
Internal Rate of Return (IRR)
The internal rate of return is the discount rate, or interest rate, used to produce an NPV that equals zero. A higher IRR is better. But like NPV, the IRR calculation is dependent on the timing of cash flows throughout the years when you are holding the investment property. You can learn how to calculate the IRR for an investment opportunity on Investopedia or use Microsoft Excel’s IRR functions. The IRR function can be used to find the IRR for investments with cash flow streams over regular periods of time. The XIRR function calculates the IRR for investments with cash inflows and outflows over irregular time periods.
A cap rate, short for capitalization rate, measures the rate of return on your investment based on the annual net operating income (NOI) for your property. The cap rate is calculated by dividing the property’s annual NOI by its cost or current value. It provides a quick and simple way to calculate potential returns.
To evaluate market trends, you can also research the cap rates for your investment’s location and property type. But the cap rate calculation has limitations. It only provides you with an assessment based on one year’s prospective annual NOI, for the year when you plan to buy or sell the property, and net income numbers tend to be incomplete because they don’t account for all expenses, including financing or tax issues. For more information about the usefulness and limitations of cap rates, check out this article from Bigger Pockets.