In Real Estate Bulls we mentioned that the typical reasons to invest in real estate are: price appreciation, cash flow income, inflation hedge, and tax shield. But instead of naming the common reasons, we could have used just one word: profit.
Net Present Value (NPV) is a tool to calculate profit. It is an objective tool; it does not factor in property-specific elements such as location, physical condition, nor the tenant mix. Instead, NPV looks at future cash flow and estimates their present value.
Two rules direct the NPV-based decision-making process. The first rule is that if NPV is above zero, then expected return is higher than required return. The second rule is that if an investor has two different projects from which to choose, the project with the higher NPV would have the potential for higher profits.
NPV requires three inputs.
The first input is the After Tax Cash Flow (ATCF). Operating expenses, debt service, and taxes are deducted from net operating income to arrive at this cash flow measure.
The second input is the After Tax Equity Reversion (ATER). It relates to the sale of the property. Disposition costs, loan balance, and any payable taxes are deducted from the sale price.
The third component is a Required Rate of Return. It is an element dependent on capital market conditions and the investor’s perceived risk and return profile.
Peter Dunn, a financial advisor, writes in What Rate of Return Should You Expect to Earn on Your Investments? that a reasonable Required Rate of Return is eight percent. In the example below, we will follow his estimate.
Sorrento Garden Apartments
Sorrento Garden Apartments is a 25-unit complex that generates an NOI of $640,000 per year. NOI growth rate is expected to be five percent each year. The apartment complex listing price is $5.25 million and it can be financed with a $3.93 million 1st trust deed mortgage from a CMBS lender. Let us assume a four year investment horizon, an exit price of $7.8 million, and selling costs estimated at seven percent of the sale price.
In the following two tables, we calculated the estimated after tax cash flow.
We also estimated the after tax equity reversion, the proceeds from the sale of the property.
In short, because Sorrento Court NPV is $3.0 million and the required equity is $1.32, a dollar of investment price is expected to bring a $2.27 of value.