Profitable investment opportunities arise when the purchase price of the asset is below the underlying intrinsic value of that asset. Learn how to determine the intrinsic value of your income property so you can capitalize on inefficient market prices.

Value investors evaluate an investment opportunity by understanding the relationship between value and price. Therefore, the essential task of a successful real estate value investor is to determine the intrinsic value in order to capitalize on the inefficient misquotation of the market.

An accepted practice for determining the intrinsic value of income-producing real estate investment assets is to find the present value of the future cash flows, known as the net present value (NPV). Present value is correctly calculated as the sum of current and future cash flows with each dollar of future cash flow appropriately discounted to account for the time value of money. Future cash flows are discounted to present values ​​using that interest rate that the investor could earn in the next best investment alternative (opportunity cost of capital).

Forecast change that creates assumptions in future cash flow, as a result of the value creation strategies mentioned in this book, should be done conservatively, taking into account a thorough market analysis.

Let’s use a sample of an investor buying a property for $1,000,000 cash that has a value creation opportunity. Our investor can find an alternative investment of similar risk with a return of 7% (discounted present value). The property will be held for four years and will then be sold.

INITIAL INVESTMENT ($1,000,000)

YEAR 1 – CASH FLOW $0

YEAR 2 – CASH FLOW $50,000

YEAR 3 – CASH FLOW $60,000

YEAR 4 – CASH FLOW $1,800,000 (INCLUDES INCOME FROM SALES)

NET PRESENT VALUE (NPV) – $1,465,861

Our investor can buy a property for $1,000,000, below the intrinsic value of $1,465,861. It looks like a good value opportunity, assuming our investor made reasonable and conservative forecast assumptions. The forecast of future cash flow and sales price should be guided and supported by factual data. Also, the discount rate should reflect market conditions. An increase in discount yield from 7%, in the example, to 13% would reduce the NPV to $1,184,714.

The calculation of the NPV was carried out using a financial calculator. If you don’t already have a financial calculator, I highly recommend getting one. A financial calculator will help you assess value and returns. I use an older version called the HP12C, which is still sold today. Using my HP12C, I calculated the Internal Rate of Return (IRR) at 18% on this sample investment.

To find the most accurate intrinsic valuation, investors must determine both the replacement cost and the net present value of the investment asset. Addressed Net Present Value is most often used with income-producing rental properties. The most accurate measure of intrinsic value is to combine the replacement cost approach and the net present value approach to find an average valuation.