By Jimmy Clark
Jones Lang LaSalle
“NPV and IRR” … If you went through any finance course in college or graduate school, you are most certainly familiar with these terms.
NPV, or net present value, is a calculation that discounts, at a given rate of return, the net cash flows from operating and selling a property net of the discounted value of the original or future cash investments. Basically, this metric enables owners to see how much profit they might expect to earn above the cost of capital.
IRR, or internal rate of return, shows an owner the actual rate of return on the investment while taking into account all cash inflows and outflows. It is a good tool to use while comparing different investment opportunities.
The concepts aren’t very difficult to grasp, so why can’t all owners find at least some success using them? There are tons of reasons: accurately timing the market, preferred asset holding periods, mitigation of risk, debt/equity positions…the list goes on.
In addition to NPR and IRR, there are a few additional calculations that owners/investors should take into account in order to dig even deeper into a possible investment:
Cash on Cash Return is the annual pre-tax cash flow over the total cash invested into the project. This can help owners evaluate their equity position in a property. Conversely, an owner can take this information and assess how leveraging the property could affect cash flows and IRR going forward.
The Profitability Index is the ratio of the NPV of an investment to the total investment. This metric helps an owner evaluate several investments that might feature different capital contributions. Additionally, the PI can help find what the ideal holding period would be for an asset.
A savvy owner/investor not only needs to understand these concepts, but also external factors (economic patterns, market conditions), capital markets factors (availability and sources of funds), property factors (location, type of product), and barriers to entry.
It’s not always easy to identify a great investment opportunity, but after utilizing these financial exercises as well as evaluating all of the non-financial aspects listed above, the chances of making a sound investment will significantly increase.