Our previous article illuminated how money has a time value, i.e., money in your pocket today is worth more than the same amount to be collected in the future. The time value of money is expressed as interest, the extra amount a borrower pays, or lender receives above the repayment of the original amount. When you take a convenient loan from Specialty Lending Group, you pay a modest interest amount each month until you repay the loan. This is a sensible business arrangement if your project will net you more money than you spend – after all, why would you borrow money for a real estate project if you expected to lose money on the deal?

Two methods that professionals use to evaluate the potential return on a project is the net present value and internal rate of return. Both depend on the time value of money to discount future cash flows, such as the lump sum you’ll receive on a fix-and-flip, or the rents you’ll collect on a fix-and- lease. Let’s see how this works.

**Net Present Value (NPV) **

If we stipulate that a dollar received today is worth more than a dollar you’ll receive in a, say, a month, that must mean that the future cash flow is worth less than $1.00. That difference is expressed as a discount factor, which is just an interest rate — in this case, the rate that would express all cash flows as if they occurred on the first day of the project. The discount factor reduces the value of future cash flows as an exponential function of time – the later the flow, the less its value. You can use the Excel function NPV to calculate net present value. If you end up with a negative number, then the project is a money loser.

In a fix-and-flip project, you typically have an initial series of outflows, culminating with a large inflow at the end representing the net proceeds from the closing. In a fix-and-lease project, you assume a perpetual series of cash inflows once you start leasing out the property. If you plan to collect rent for five years and then sell the property, you would have 60 cash inflows, followed by a single inflow representing the sale of the property.

**Internal Rate of Return (IRR) **

The IRR function lets you find a rate of return (the “annualized effective compounded return rate”) that will exactly equate cash inflows and outflows. All things being equal, the higher the IRR, the better the project. IRR is useful when you are considering two or more mutually exclusive projects. All things being equal, the one with the highest IRR is the winner, although considerations other than return might sway the ultimate decision.

You can calculate IRR use the Excel function of the same name. With both NPV and IRR, the higher positive value wins, but many folks feel that IRR is more intuitive. While this is debatable, what’s not debatable is the importance of accurately estimating future cash flows. The old saying “garbage in, garbage out” applies here, so it often pays to run best, worst and most-likely scenarios to get a better feel for the risks and rewards of each alternative.