This paper proposes an investment assessment of real estate purchases through an analysis of net present value and cash flow construction. For the study, a space for sale in New York was selected, measuring 15,500 square feet and costing $150,000 (Crexi, 2024). It is assumed that the favorable building in a populated city will, if necessary, be divided and rented out after cosmetic repairs for retail sites.
The renovation is expected due to the building’s construction in 1900. Still, there are many necessary communications inside, so there is no need to resort to significant repairs. However, the area is promising for business – Canisius High School and Buffalo Academy for Visual and Performing Arts are very close by (Crexi, 2024).
The premises are located near bus stops, which also provides an advantage in location for potential tenants. According to recent data, a significant renovation costs $500 per square meter, while a cosmetic renovation costs up to $25 (Bigrentz, 2023). Accordingly, the renovation will cost approximately $387,500, bringing the total initial costs to $537,500.
Buying a building and carrying out renovations are fixed costs in this calculation. On average, the price of utilities, which are variable costs and will constitute expenses when calculating cash flows, is about $2.10 per square meter per year; however, the data is given for 2020 – since then, there has been relatively high inflation in the USA, so it is necessary to increase this figure to $3 (Iota Comm, 2020; Trading Economics, 2024a). Accordingly, the annual utility payment will be about $46,500. In addition, it is necessary to set a budget for marketing and advertising the premises for potential tenants – for ease of calculation, it will be set at $3,500 per year so that the total variable costs will be exactly $50,000.
Next, the potential profit needs to be calculated. On a given city street in this state, rental prices reach about $17 per square meter (LoopNet, 2024). Accordingly, if the building is fully leased, the company will be able to earn $263,500 per year; however, this amount should be rounded up to $250,000 to account for downtime and the creation of infrastructure in a small, specific area for clients. Finally, it remains to determine the discount rate; once that is done, calculations can proceed.
There are several formulas for calculating the discount rate. Still, none apply to the direct method, as each is either not suitable for the type of asset or lacks certain variables for calculation. Consequently, the building is assumed to be purchased for 7 years, after which it will be rented out.
The current inflation rate in the US is 3.5%, and for real estate, this rate is unlikely to fall anytime soon, even with high Fed Fund rates (Trading Economics, 2024a). The interest rate indicator is currently 5.5%, which can be taken as a discount rate, since at this level it is possible to buy government bonds that provide a given yield for the long and short term (Trading Economics, 2024b). However, it is generally believed that this rate should be several hundred, or tens of, basis points higher across all sectors except banking, to set it at 7% in this paper.
Table 1 – Net Present Value Calculation with Expected Cash Flows
Calculations were carried out using the Excel software package and the corresponding NPV function. Table 1 shows the calculation results. From this, it is clear that, with the given costs and profits, the project will pay off only in the third year, while the NPV is $548,214.68. It follows that purchasing real estate is a profitable activity at the specified discount rate of 7% – a sensitivity analysis shows that the NPV remains positive until this rate increases to 17%.
Cash flows do not account for inflation. However, it is assumed that rent will grow in parallel with utilities, thereby neutralizing the effect; in the end, the investor will be left with an asset that has appreciated. In addition, potential costs for additional repairs may be driven by both external factors and the need to update the infrastructure in a few years.
However, at the moment, the project has a certain margin after a specific period, allowing cosmetic repairs or even part of the significant repairs to be carried out again. The investment is attractive due to the relatively low cost of acquiring a reasonably large building that can be used and subsequently rented out, even with repair costs exceeding twice the purchase price. In addition, the NPV and cash flow analysis yielded positive results with a sensitivity margin on the discount rate, leaving a possible future contingency fund for the investor.
References
Bigrentz. (2023). 2023 Commercial construction cost per square foot in the US.
Crexi. (2024). 1462 Main St, Buffalo, NY 14209.
Iota Comm. (2020). What is the average utility cost per square foot of commercial property?
LoopNet. (2024). Cathedral Place298 Main St.
Trading Economics. (2024a). United States Inflation Rate.
Trading Economics. (2024b). United States Fed Funds Interest Rate.