In commercial real estate investing, two commonly used terms are net present value (NPV) and internal rate of return (IRR). NPV has primarily to do with the value of cash, while the IRR chiefly involves variables such as time value of money. What the two mainly have in common is they’re both used in the evaluation of investment projects, both current and potential. The two can help investors make decisions based on the potential for cash flow.
Let’s take a long view of net present value vs. internal rate of return.
What is Net Present Value?
Let’s define terms. Net present value is essentially the difference between the current value of cash inflows and the current value of cash outflows – over a certain period.
What is Internal Rate of Return?
Internal Rate of Return is a tool used to evaluate a real estate investment’s performance – over time. Technically, it’s whatever interest rate that causes the net present value – there’s that term again – to equal zero.
How are NPV and IRR Similar?
Both metrics are used to help investors make decisions about whether to take on a project. What’s more, both tools employ the discounted cash flow, recognize the time value of money, and factor in the cash flow throughout the investment’s life cycle.
How are NPV and IRR Different?
Both internal rate of return and net present value are widely used metrics for investment evaluation. Here are some of the differences in these areas:
- Net present value helps investors figure out the profits a project will likely produce. On the other hand, internal rate of return is most effective at determining an investment’s break-even cash flow level.
- Outcomes. Whereas NPV produces a dollar value of a project’s cash flows, IRR results are expressed as a percentage.
- Making decisions. In terms of helping with decision-making, some investors prefer NPV because it generates a dollar return. In contrast, IRR does not indicate how much money an investment will likely produce.
- Calculation variables. NPV is relatively hard to calculate because it involves discount rates. These can be difficult to pinpoint because several variables must be considered.
- Utilization. NPV has several uses: to evaluate new investments such as in real estate; to lower operating costs; to determine a business’s value; and for capital budgeting. IRR has a chief, albeit important application, and that’s for budgeting a proposed project. It is also used to help investors choose between projects.
- Reinvestment rate. With NPV, the reinvestment rate is a new investment’s capital cost, with cash flows reinvested at cutoff rates. The reinvestment rate is equal to the IRR when, using the IRR metric, capital expenditures are estimated.
- Circumstances. When circumstances are similar, you’ll see NPV and IRR results are similar. It’s when conditions change that the tools produce dissimilar results.
- Market rate of interest. NPV uses the market rate of interest for capital costs to fix a potential project’s prospective earnings.
- Cash flow variations. NPV results are not affected by varied IRRs or multiple cash flows. In IRR, cash flow variations will cause results to be negative.
If you’re investing in real estate or are considering getting into it, it’s important that you know the ins and outs of net present value vs. internal rate of return. If you are interested in learning more, the alternative investment platform Yieldstreet – which offers real estate investment opportunities, by the way – has resources available to help you.