Real estate professionals approach each transaction hoping to achieve the best possible deal. Often, the first metric they’ll assess is the property’s net operating income (NOI). But this won’t be enough for savvy investors. In most cases, you’ll need to dig deeper to find the property’s highest and best use.
Why not NOI?
NOI is the property’s net rental income after operating expenses, including such items as:
- Janitorial services,
- Insurance, and
- Accounting and management services.
This financial metric isn’t always what it’s cracked up to be. Unfortunately for unwitting buyers, sellers may skew NOI by operating properties in a “soon-to-be-sold” mode in the year before the sale.
For example, sellers may artificially inflate property income by billing in advance, basing billing on inflated estimates and collecting lump sum payments. Deferring repairs and classifying operating expenses as capital items are other ways for sellers to inflate NOI and, with it, selling price.
What should you do in this situation? Don’t rely on numbers that you can’t independently verify. A zero-based budget with numbers that you as the investor develop can be a helpful tool. The goal is always to be aware of the maximum price you can pay and still receive an adequate rate of return in light of the associated risks.
What is NPV?
When investors value properties using NOI, they typically capitalize a single year of earnings. However, it may be more meaningful to discount net cash flow over several years. Net present value (NPV) is a more sophisticated analytical tool that considers the property’s projected:
- Cash inflows (such as rental income, debt proceeds and eventually selling proceeds), and
- Cash outflows (such as operating expenses, capital expenditures, principal and interest payments, debt service and selling expenses).
NPV is generally the preferred method for evaluating rehab projects or properties that are under construction, because it allows annual cash flows to fluctuate until the investment generates a more predictable income stream and qualifies for permanent financing. At the end of the discrete discounting period (which is usually three to seven years), investors may calculate a terminal (or residual) value. The terminal value essentially equals what the property could sell for at the end of the projection period. It may also be calculated using replacement cost, comparable properties or NOI-based appraisal techniques.
To calculate NPV, the investor projects annual net cash flows for a proposed investment property and then discounts these amounts to their present values. NPV equals the sum of these present values, including the present value of the terminal value. The appropriate discount rate for real estate investors generally takes into account the opportunity cost, or the rate of return that the investor can earn on an investment that’s comparable in size, risk and duration.
A positive NPV indicates that the investment has good potential or a safety factor against future shortfalls. A negative NPV indicates that the property may fall short of the target yield and the investor needs to withdraw (or lower) the offer, increase the projected cash flows or accept a lower rate of return.
What about IRR?
Internal rate of return (IRR) is one of the most popular methods for evaluating and comparing investment returns. You can use it to compare real estate opportunities with alternative investment options.
Closely related to NPV, IRR is the discount rate at which the NPV for an investment equals zero. You can use IRR in conjunction with NPV for an understanding of a potential project’s value. Most investors compare a property’s IRR to a prescribed “hurdle rate.” The logic is: If an investment’s IRR exceeds the investors’ preferred hurdle rate, it’s generally worth pursuing.
Is it right for you?
NOI, NPV, IRR. There are many acronyms to consider. To determine what’s best for your real estate investments, contact your tax and financial advisors.