Rental Property Investment: NPV and IRR Scenario Analysis

Introduction and Investment Overview

This paper examines an investment in a rental real estate property. The investment involves a one-time purchase of $10,000 in land that can subsequently be rented for $3,500 per year over a period of several years. At the end of the rental period, the investor aims to sell the land. The longer the rental period, the more the land will degrade and, as a consequence, the lower its resale value will be at the end of the period.

The scenarios considered in this analysis therefore reflect a trade-off: a longer rental period generates more annual income but results in a lower final sale price, while a shorter rental period preserves land value but reduces total rental income. This paper examines three distinct scenarios, each analyzed using net present value (NPV), internal rate of return (IRR), and related cost-effectiveness and benefit-cost instruments. The conclusion identifies which scenario is optimal for the investor.

An important parameter common to all calculations is the discount rate, which is set equal to the cost of capital — that is, the rate at which the investor would borrow funds to finance the property purchase. For all scenarios in this paper, the discount rate is assumed to be 12% (0.12). All calculations were performed in Excel, with a separate worksheet created for each scenario.

Scenario A

Scenario Definitions and Cash Flows

The investment in the rental property is $10,000, recorded as a negative cash flow at Year 0. The property is rented for three years, generating $3,500 per year in Years 1, 2, and 3. In Year 4, the property is sold for $3,500 — a price reflecting the gradual depreciation that occurs during the rental period.

Scenario B

The investment in the rental property is again $10,000 at Year 0. The property is rented for five years, generating $3,500 per year in Years 1 through 5. The extended rental period results in greater wear on the property, so it can only be sold for $1,500 in Year 6, which is recorded as the cash flow for that year.

Scenario C

The investment in the rental property is $10,000 at Year 0. In this scenario, the property is rented for only two years, generating $3,500 in Years 1 and 2. Because the property has experienced less wear, it commands a higher resale price: it is sold in Year 3 for $4,500, which is recorded as the Year 3 cash flow.

Net present value takes into account the present value of all future cash flows that a project is expected to generate. For each year in each scenario, the projected cash flow is discounted at the cost of capital (12%) to obtain its present value. The sum of all discounted future cash flows is then compared to the initial project cost of $10,000 (shown as −$10,000 in the calculations). A positive NPV indicates a profitable investment; a negative NPV indicates a loss in present-value terms.

The NPV can be calculated manually by dividing each year's cash flow by 1.12 raised to the power of the corresponding year (since 112% = 100% + the 12% discount rate), summing those present values, and subtracting the $10,000 initial investment. In this analysis, the built-in Excel NPV function was used for each scenario. The results are as follows:

Net Present Value Analysis

These results are both conclusive and informative. Scenario B is the best-performing scenario, with Scenario A in second place and Scenario C not only ranking third but also producing a negative NPV — meaning the investment would be unprofitable under those conditions. Scenario B features the longest rental period (five years of income) and the lowest resale value, yet it generates the highest NPV by a significant margin. Scenario C, despite its higher resale price, yields a negative NPV because the shorter exploitation period does not generate sufficient total cash flow to justify the initial outlay. The intermediate case — Scenario A — confirms the trend: the longer the rental period, the more profitable the investment, even when the final sale price is lower.

According to Project Economics and Decision Analysis, Volume I: Deterministic Models, the internal rate of return is the discount rate at which the NPV of a project equals zero. While the NPV analysis evaluated each scenario at a fixed 12% discount rate, the IRR identifies the breakeven discount rate specific to each scenario — the rate above which the investment would become unprofitable.

The IRR results for each scenario are as follows:

These results are fully consistent with and validate the NPV findings. Scenario B, which had the highest NPV, also has the highest IRR. Its IRR of 24.10% means that even if the cost of capital were as high as 24%, the investment would just break even; at any rate below that, it remains profitable. If the discount rate were, for example, 20%, Scenario B would still yield a positive NPV. By contrast, Scenario C has an IRR of just 7.01%, which is below the assumed cost of capital of 12%. This confirms that even under favorable borrowing conditions — say, a cost of capital as low as 7.5% — renting the property for only two years and selling it at a premium in Year 3 would not constitute a profitable investment strategy.

For a broader discussion of how IRR relates to other capital budgeting methods, including its limitations in cases involving multiple sign changes in cash flows, see Hazen (2003).