I usually tend to stay away from technical posts because, quite frankly, there is nothing I can write about that hasn’t already been covered ad nauseam. However, in searching NPV vs. IRR, there was little information on the difference between the two and when to use each.
The net present value (NPV) and internal rate of return (IRR) are the two most commonly used methods to examine a proposed investment. Until recently, I really couldn’t tell you anything but the major differences between the two. All investors have their personal preference, so I wanted to lay out the facts, using examples, so you could decided which you prefer.
Net Present Value: To calculate the NPV of an investment, you choose a discount rate that you believe is appropriate given the inherent risk of the investment and you discount back all of the after-tax cash flows at that rate (less your equity). This will allow you to see the amount of profit you might expect to earn above your cost of capital, and to determine whether or not the profit is great enough to warrant the risk and work involved with the investment.
Example:
The purchase price is not included in these cash flows because we are calculating how much the investor is willing to pay. The NPV of the cash flows above, when discounted at 14 percent, is $118,565.
IRR: Alternatively, the internal rate of return shows you what the actual rate of return on your investment is, considering all of the cash inflows and outflows as well as assuming that interim cash flows can be reinvested at the same rate. Like, NPV, we use bottom of the line items.
Example:
(click to enlarge)
This is the rate that makes the present value of the projected cash flows equal to the initial investment or the return on the entire property. As you can see from this example the IRR can remain constant although the initial investment, holding period, and payback period may vary greatly.
The Difference between NPV and IRR: Both NPV and IRR take into account when your money is invested and for how long it is invested. However, in deciding which to use, I suggest run both calculations. Sometimes the IRR can be really high, but if the payback period is very short, the money you will make may not be worth the effort. Also, it’s very difficult to compare alternative investments if you only have the NPV in dollar terms.
Whichever you use, the critical thing to understand is what exactly drives the returns. It could be from the cash flow of the property over time, or value-add by raising rents, reducing vacancy, or lowering expenses. Or it could be the future benefits that will result from selling or refinancing the property. Maybe you’re anticipating a change in cap rate at the time of the sale. When using IRR I recommend analyzing both the IRR from the cash flow and the IRR from the reversion. No matter what, it’s important not to get tangled up in the numbers. Look beyond the spreadsheets, in the end, it’s a real property designed for use by real people.
Which do you prefer in your financial analysis, NPV or IRR?
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{ 10 comments }
Joe,
First off, I've been a fan of your blog for awhile now. I'm a young professional in the NY commercial real estate field for about 4 years now (I'm an appraiser), so reading up on other peoples opinions about the market is something I enjoy doing (plus, I have to know these things since its my job).
So when I read your recent blog entry about the NPV vs the IRR, I had to let you know where you went wrong. This is a quote from your article:
“The net present value (NPV) and internal rate of return (IRR) are the two most commonly used methods to determine the return of a proposed investment.”
Now, this statement is half correct. The IRR is one of the two most commonly used methords to determine the return on a proposed investment. But where you seem to be confused is with the NPV. The net present value is the overall return on the proposed investment. The IRR is simply the rate used to discount however far into the future you are going's cashflows.
The problem with the article is you're comparing the discount rate with the overall value. Apples and oranges.
What I think you're trying to write about is the IRR vs. the Cap Rate. These are both two different rates that investors use to to determine the return of proposed investment, as you put it. The IRR is the discount rate used to find the NPV of a Cash Flow for multiple years into the future, while the Cap Rate is a discount rate used to capitalize the next years NOI into a value.
Louis – Thank you so much for the kind words. I really appreciate your feedback. You're definitely correct in your assessment.
I've changed that opening line to: “The net present value (NPV) and internal rate of return (IRR) are the two most commonly used methods to examine a proposed investment.”
However, the post is in fact intended to compare IRR vs. NPV.
Maye something I should mention is that people should look at the profitability index, that is the ratio of NPV to the total investment.
Does this make sense?
What I think you're confusing here, is that the Net Present Value isn't a method used to examine the return on an investment. The Net Present Value is just that, the overall value.
You're comparing a discount rate against the overall value, which isn't correct. It can't be IRR vs. NPV because you are using the IRR to get to the NPV. This is why I am bringing up the IRR vs. Cap Rate issue. These are two different rates that investors use to determine the value of an investment using the cash flow.
As for the profitability index, while it fits into this discussion somewhat, I would figure that is another article all together. It is another way investors determine value, but I personally don't believe it fits into what you are trying to show with this latest article. Maybe a future blog about the profitability index (and maybe income multipliers) as separate forms of determining value for an investor?
I agree that the profitability index is material for a future blog post.
I understand that the NPV is calculated in terms of a value where as the IRR is calculated in terms of a percentage return. Despite being different, they are two ways to examine/analyze a proposed investment.
IRR is not really used in a DCF, but rather a discount rate, which is not exactly the same. The discount rate is market derived/ determined somewhat arbitrarily based on a number of factors including; alternative investments, risk premium, time etc. IRR is determined formulaicly.
It would probably be helpful for readers to point out the simplest of the relationship between NPV and IRR – when your IRR is zero, your NPV is zero.
Broderick, thanks for your comment. You make a very good point, stepping back and looking at it from a simplistic view definitely helps. To add, the IRR is a Discount Rate, but the Discount Rate isn't the IRR.
“The IRR is the discount rate used to find the NPV of a Cash Flow for multiple years into the future.” The IRR is equal to a discount rate that will make your NPV calculation equal zero. IRR also assumes that an investor is able to immediately reinvest the cash flows at the same return. This is usually not the case. A more accurate measure of return would be a modified IRR.
IRR can be tricky as some investments may have multiple IRR's due to the volatile nature of the cash flows.
It is also important to note that the IRR equation does not take into consideration the scale of the initial investment nor the cash flow patterns (relevant when the higher npv project has a longer duration). With regard to scale, a smaller investment may have a larger IRR when compared to a larger investment, but a smaller NPV. Would you rather return 100% on $10 or 50% on $100?
In my opinion, when evaluating a multiple projects a NPV calculation will always help clarify the return potential but the IRR calculation will not.
Nathan, thanks for your comments. The IRR is definitely tricky, and you're right, the equation doesn't take into consideration the scale of the investment nor the cash flow patterns (see the example).
I also agree, it's important to run both an IRR and NPV calculation to understand exactly where the return is coming from.
How was your experience at the Cornell Real Estate Program? What are you up to now?
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