I am working on a few interview questions and this one I cannot understand how to answer. Even though the question seems abstract can anybody provide some pointers?
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NPV is the discounted value of future cash flows minus the PV of what you paid for the asset, so it's a dollar amount. Think about it this way - if I told you I expect to make PV $10 million dollars on my investment (i.e. if I gave you the NPV), could you tell me whether I made a good investment or not?
The answer is no, because you don't know how much I invested into the asset, and you don't know how long I've held it for. If i invested $1 million and made PV $10 million in one year, that's a pretty good investment, but what if I invested $1 billion and that return was over a hundred years? That should illustrate to you why a PE firm would look at a percentage return that accounts for the timing of cash flows as well as the dollar amount of cash flows.
Note that there is also cash on cash returns, which is another metric of return that a sponsor may look at. To get that, you just divide your exit cash amount by your entry cash amount, and you might look at this return to get a sense for how much you increased the size of your "pot".
The NPV method is inherently complex and requires assumptions at each stage - discount rate, likelihood of receiving the cash payment, etc. The IRR method simplifies projects to a single number that management can use to determine whether or not a project is economically viable. The result is simple, but for any project that is long-term, that has multiple cash flows at different discount rates, or that has uncertain cash flows - in fact, for almost any project at all - simple IRR isn't good for much more than presentation value.
NPV vs IRR and IRR dominance as a metric in CRE Finance (Originally Posted: 10/16/2012)
I did a search and didn't find anything.
Why is IRR used predominantly over NPV in CRE finance? While almost everyone can agree they both should be looked at, I don't know why IRR is seen as "better." What's particularly interesting is that in some other areas of finance NPV is seen as "better." The CFA curriculum goes so far to suggest it over IRR (because of the reinvestment assumption implicit in calculating NPV).
This is all based on "book" knowledge that I know -- so people more experienced in the marketplace should be able to offer commentary.
Perhaps the difference is just arbitrary or historical, but it might also something that has sound reasoning -- I don't know.
I think NPV makes more sense but IRR is easier to do because you don't need to choose a discount rate, it's built in. When comparing two cash flows A and B, whether NPV(A) > NPV(B) or NPV(A) IRR(B) Does NOT imply that NPV(A) > NPV(B).
see http ://people.stern.nyu.edu/wsilber/NPV%20Versus%20IRR.pdf
IRR is easier to reference when the amount of the initial investment is assumed(or present value is already assumed to be of substantial amount to be discussed.)
The problem I see, from my limited experience, with IRR is that it's so biased to short time-horizons. Who cares if you have an IRR of a million percent of your NPV is only $10,000 dollars -- the project may not be worth undertaking.
IRR and NPV are simply different parts of the same equation. After all there are really three components to any investment: (1) how much I pay today (or, similarly, what it's worth today), (2) what the future cash flows are, and (3) the returns. In an NPV analysis, you give your model #2 and #3, and it tells you #1...how much you can pay. In an IRR analysis, you use the same future cash flow inputs (#2), but give the model a purchase price assumption (#1) so that it tells you your returns (#3) rather than the other way around. The sensitivity of short time horizons is irrelevant if you're consistent in your methodology for projecting future cash flows.
The relative dominance of IRR can be traced to a number of factors. Perhaps the most meaningful reason is you often have a given price you intend to bid for a property, so it makes sense that price (factor #1 in our example above) be an input rather than an output...after all it's the returns that are in question, not the price. The next main reason is that IRR is a number that is meaningful ex post, and one of the main benchmark against which fund managers are judged. NPV has no meaning at the conclusion of an investment, only at its inception.
The reason why NPV matters in public market investing is because you have a market that can re-price assets on an instantaneous basis. So if you find an asset that's mispriced and deserves a lower discount rate, you can buy it and hope to realize your calculated NPV in the short-run if the market corrects. Even a 5% discount to NPV is meaningful if you have reason to believe a short-term catalyst will close that gap in the next few months. You don't have that kind of real-time pricing in real estate, so you need to be comfortable with your projected IRR, not the mere fact that you're buying at a discount.
doublepost, sorry
This explanation is gold. Every prospective monkey should read it
1/1/2013 -1000, -1000 1/1/2014 1000, 0 1/1/2015 200, 0 1/1/2016 100, 0 1/1/2017 1, 1000 1/1/2018 100, 1000 irr 26%, 17% npv $192.99, $276.30
Here I just scratched out some simple stuff in 5 seconds. Which project would you invest in? IRR and NPV give conflicting answers. Is there any situation in CRE (real world situation -- it would be easy to create an unrealistic one) in which you have conflicting investment opportunities, and you would invest in an opportunity based on NPV instead of IRR?
I will still go with the second investment that has a higher NPV based on incremental IRR calculation
The incremental IRR for the two investments is 12.69%
At this IRR, both investments yield an NPV of $170.36 and an equivalent annual annuity of $48.08
Thus if your cost of capital is below 12.69% then you are better off selecting the second investment
In terms of time, the first investment takes only 1 year to recover the cash outlay in contrast to 4 years with the second investment
In addition to IRR, the second metric that is often looked at is multiple, which is an instructive factor here. In Investment #1, the IRR is 26% and the multiple is 1.4x (1 + sum of profits / peak invested capital). In Investment #2, the IRR is lower at 17%, but the multiple is higher at 2.0x. The second deal returns more profit but takes longer.
The discount rate you used to arrive at the NPV was 10%, which is why that calculation favors the second deal. After all, if you use a 0% discount rate you're saying that time value is irrelevant and so the deal with the higher multiple will always win. As you increase your discount rate, the deal that returns money faster will look more and more attractive (see what happens when you use a 17% and 26% discount rate, respectively).
Both IRR and multiple are important components to an investment. Usually fund managers are paid against IRR hurdles, so no matter how high the multiple, an investment will be expected to clear a minimum IRR. On the multiple side, things are a little more flexible. You'll want to make enough gross profit for the deal to be worth your time, but that's a function of both size and multiple. The IRR vs. multiple decision comes into play on sale as well. If a deal can be sold today at a very high IRR, you have to decide whether to hold out longer, which will probably drive down your IRR but increase your multiple.
This might not be the answer you're looking for, but institutional investors (pension funds, insurance cos, multi-family offices, and other LPs) need an IRR measure for their asset allocation. i.e. they need projected returns to plug into their asset allocation models that decide how much to invest in real estate funds versus other asset classes. This trickles down to how managers are compensated and how deals are underwritten, to some extent.
Also, brokers and people who discuss deals and the market use yields (Cap Rates, or Net Initial Yields) to communicate what is going on in terms of market valuations or recent transactions much in the same way bond investors do. An IRR is a natural extension of this kind of communicating because it is in yield terms as opposed to a wealth number/dollar amount.
Personally, I prefer to think in NPV, intrinsic value and incremental addition to wealth terms. But since most CRE investing is done through funds, IRRs matter a lot more for professional investing whether in an investment committee memo, when pitching a deal to co-investors, or too see which deal would make us more carried interest and other fees.
Bro, year and a half old thread. Let it go.
I am sorry, I didn't realize that invoking the dead beast was not allowed
hahaha hilarious.
And Abraham, that question really depends on the firm / institutional partner and how they allocate capital. Some are more multiple driven & some are more irr driven. Some are more risk averse. There are so many factors that there is no right or wrong answer to that question.
NPV vs IRR (Originally Posted: 01/08/2014)
Two Investments:
Investment A: 3% IRR, 4 million NPV Investment B: 6% IRR, 2 million NPV
Which is the better investment, and why?
B. I know the CFAs will say A.
Let's get some color for the audience!
Always go with NPV. It tells you the amount of wealth you expect to add by taking on the investment.
LP: 6% so I hit my waterfall.
Investment B implies that you are investing less capital up front compared to Investment A Therefore you can take that excess capital and invest it elsewhere at anything over a 3% IRR.
This was my thinking. And I'll be damned if I can't invest in something for more than 3%.
This rationale is beyond the scope of the question though. In a vacuum, Investment A is better.
Though, I may be approaching this too much from a "test-taking" perspective, and not enough from a practical application perspective.
What about the time horizon of the investments? If they're equal and there are no other investments available take the higher NPV. If these stipulations don't hold then the answer requires more of a conversation.
More NPV is better given the two are exclusive
I will never understand the lack of respect and vitriol displayed on this site sometimes. Both of you guys are industry professionals and neither is "dumb". If you disagree then do so politely.
I agree. It would make wso a better place to seek advice.
If the life time of both investments is equal, then selecting the better of the two investments would be possible once you calculate incremental IRR and incremental NPV
If the two projects have different life terms, then finding replacement chain NPV can help determine the better of the two investments.
Is the two investments have same life but cost of capital for each investment was different, then finding equivalent annual annuity will help determine the better of the two investments
As both investments have different IRR values and different NPV values, you may want to find the "Duration" of each investment that will show the percentage rate by which each NPV will increase or decrease when IRR is decreased or increased by 1%
How many of you other PE guys only use IRR? (Originally Posted: 01/06/2017)
My group is small but widely known in our industry market backed by ex-Wall Street execs, NYSE CEOs, etc. I was shocked when I got here to find that they don't use NPV as an investment decision metric, strictly IRR and cash-on-cash, revenue growth prodictions. Is this a norm with other shops as well? It has obviously worked for us, but anyone who has taken undergraduate real estate courses is taught that NPV is metric numero uno.
Thoughts?
We are never really caught between any mutually exclusive investment decisions and are very well capitalized. Maybe that's why....
We calculate NPVs and show it but people only really care about IRR, ,c-o-c, yields here
We use all of the ones you mentioned plus equity multiple. I could be way off base here, but I've always thought about NPV and IRR as two sides of the same coin.
Agreed. I mean, they're a function of one another...
Not in PE, but with a sponsor/operator and we have NPV calcs in the model but its never discussed. As others have said, Cash on Cash, Multiple, & IRR are the main topics of discussion.
I agree with what everyone has said above.
For mutually exclusive projects, though, I'll look at NPV more closely ... because it's possible that Project A produces a 30% IRR and $4mm NPV and Project B produces a 20% IRR and $7mm NPV. Assuming the assumptions aren't BS, you should be picking the $7mm project (unless you have a return threshold). That's the only scenario where I find NPV absolutely necessary.
Lol. What on earth are you talking about. This is just wrong unless you're comparing apples and oranges.
Feel free to explain why it's wrong. Really curious to hear your thoughts.
Think about the only way your example is possible. Now decide if it makes sense to make the statement you did. Size, leverage, horizon, etc...
If you have a finite pot of, say, $5 million to invest, there are infinite scenarios one could imagine that would have two mutually exclusive paths--A and B--where path A produces higher IRR but lower NPV than path B--use of leverage, cash flow timing, project length, initial investment, etc. all could/do impact the NPV and IRR outputs.
Use debt financing as an example. Use of debt could decrease your initial investment outlay, thus potentially increasing your IRR; on the other hand, interest and other financing fees could eat away at your NPV. So there is a scenario where leverage can increase your IRR while reducing your NPV for the exact same project--a project that has mutually exclusive paths (i.e. the apartment building at 123 1st Ave, NY, NY can only be built once so, ultimately, there is only one choice about debt/equity that can be made).
It makes complete sense. It happens all the time. If you had an opportunity to...
Invest $1 and get $2 in year 1, or Invest $2 and get $0 in year 1 and $4 in year 2
...you're saying you'd choose the former and not the latter? Even if you use a 200 bp difference in discount rates, you still get a higher NPV and profit for the latter. So how do you tell your VP or MD that the former scenario is the way to go?
I have never seen a fund operator (be it a PE fund, syndicator, etc.) describe returns to investors in terms of NPV.
What VTech said is spot on, but I would expect to see IRR and MOIC combined to illustrate the same concept rather than IRR and NPV. A deal's multiple isn't impacted by selection of an arbitrary discount rate, it just tells you how many dollars you expect to get out of a deal for each dollar you put in. Combined with IRR, you're telling your investors how much profit a deal will make and the timing of that return in an easy to understand manner.
^^^exactly what he said. NPV is used for many things in the industry but analyzing prospective investments is really not a primary one of them. IRR and MOIC are the metrics used when looking at the investment from the deal level, whether it be a JV or capital partner.
Mammaries Of Incomprehensible Circumference? You guys are crazy
Keep it simple guys. EM works just fine and isn't two letters away from moist.
Nailed it. I'm going to suggest we footnote that in the presentation for our next annual meeting.
I work at one of the larger REPE firms in the United States. The financial metrics we focus on vary by fund due to investor preference.
Ultimately, you'll find the institutional managers are not compensated on the same financial metrics. Many of them are IRR focused, but some of the larger investors are EM focused. We also have some investors that track neither IRR or EM and focus solely on TWR.
We make investment decisions that align with the preference of our investors and adjust risk to best fulfill their investment goals.
7 years in REPE never used an NPV. It's IRR and EM. IRR is the same thing as NPV - it's just the discount rate that makes the NPV equal to 0. No reason for NPV if you have IRR.
Only time I use NPV is to calc the present value of a ground lease so I can compare to land sale comps or get fee simple equivalent value. Bet you didn't think of that.
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