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Welcome to part two of my investing terms video. We’re going to continue off of the same scenario we were speaking of in my “Investing Terms Part 1” video, which discussed NOI, Cap Rate and Cash on Cash.
As a refresher of what the details were in regards to the property, we were looking at a $2m income property that made $150k NOI. We figured the cap rate was 7.5%, and that if we used leverage our cash on cash return jumped up to 8.775%.
Now, we’re going to get into the two more complex formulas. The first one we’re going to go over is called Internal Rate of Return, or IRR. The second is called Net present value, or NPV. Both of these can correlate with each other quite often, but let’s take them on one by one.
First, the IRR concept. IRR basically is looking at the investment OVERALL, from START to FINISH — and the key word there is FINISH because there must be an exit strategy — and determining how what percentage you made. So let’s take a look at our property. $2M to buy it cash, $150k for 3 years, and then at the end of the 3rd year a huge bonus of $4M. Using IRR we’ve made 32.10%. As I explained our money has made 32.10% every year from start to finish…again, the key word there is finish.
Which brings us finally to the Net Present Value, or NPV. Net Present Value means to convert all the future cash flows into today’s dollars. Which even for me is still a bit of a confusing way to understand it. Let’s go back to the bank we just left. Here you are sitting at a table with a good investor friend of yours.
You tell your friend all the details of what just happened the last 3 years. How you gave the bank $2M and they gave you back $150k every year for 3 years…then how after 3 years you went to go take your $2M out and instead they gave you $4M. You’re good investor friend explains everything about the Internal Rate of Return and basically how much money you just made year after year.
While you guys are talking, he or she asks you…how much were you okay with making??? Kind of an odd question, but a valid one. As an investor, you have to know how much you are comfortable with making. This is discussed more in my “Determining Net Present Value” video.
For the sake of argument, let’s say you tell your friend you were more than comfortable making 20%, and that over 32% was great, but MUCH higher than you expected. What you can now do is determine the Net Present Value. In other words, if you could go back in time and see what you would make per year and when you took your money out, how much *COULD* you have paid in the BEGINNING and still have made that 20%?
Well, let’s look at our property in the same fashion. Making $150k/year and you make $4M at the end of 3 years, how much more could you have paid to still make a 20% IRR? After plugging in a few numbers, the amount it $630,787. In other words, if you pay the original $2M, PLUS the additional $630,787, you’re new IRR will be 20%…right at the percentage you were comfortable with…
Now at this point you may be asking why you would need this information?? Let’s say you are looking at a property and there are a lot of interested buyers and of course multiple offers. Obviously there can only be one buyer.
By knowing your desired NPV and plugging it in your formula you can see how high would be your maximum to where you would still make your desired return. This works in the opposite manner. If you’re looking at this same property and your NPV target was 35%, you would be finding out how much LESS you had to pay for the property.
Remember that if you’re looking for a quick judgment snapshot, think of IRV for your cap rate formula. If you’re looking to hold a property for a while and what to figure out what your making after all expenses — even if you have a loan, use your cash on cash formula. If want to know the true value of your investment from start to finish, think internal rate of return.
And if you’re trying to find out the difference of what you need to accomplish to hit that target IRR, think of the Net Present Value. Of course, there’s a few more formulas out there in the investment world, but when it comes to income property, these will definitely give you a leg up in determining what your investment is really worth…now that’s good to know.
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