Real estate investing is all about numbers. Cash flow, rates of return, property value, financing, and a few dozen other ratios and measures are neither better nor worse than the bottom line.

However, getting that bottom line right must involve the time value of money because any cash flow you expect to receive in the future might not be worth the amount you think. Time value of money is the concept of measuring the value of money over time. The idea is simple. Because money never remains static and changes value over time, it must be measured over time.

For example, if you stash $10,000 under a mattress until next year, you may be disappointed to find that due to inflation alone, you may not enjoy the same purchasing power with that fistful of dollars next year as you would. I would today. Time erodes the value of money.

That’s why time value of money is crucial to real estate investment analysis and why we try so desperately to measure and figure out those changes. Yields such as Internal Rate of Return (IRR), Net Present Value (NPV), and Financial Management Rate of Return (FMMR) are used to measure an investor’s rate of return based on the value of money in the market. weather.

Of course, it is beyond the scope of this article to discuss more than the rudimentary elements of the time value of money. But if you’re new to real estate investing, perhaps with little or no experience, even a little education on the subject will help. We will consider four components: present value, future value, discount, and compounding.

Present value

Present value defines what a dollar is worth today.

For example, let’s say you have $400,000 in cash savings and if you wanted to today you could buy a duplex for exactly $400,000. Your $400,000 can then be said to have the present value (or purchasing power) of a duplex and therefore a “purchasing power” equal to a duplex.

future value

Future value defines the value of a dollar at some point in the future.

Okay, now suppose you travel back in time one year into the future and find that a duplex costs $440,000. What do you discover about your $400,000 savings? Time has devalued it. While he provides the purchasing power to buy a duplex today, he won’t tomorrow.

For this reason, because of this relationship between present and future value, some very smart people concluded that the timing of receipts might be more important than the amount received.

Let’s repeat that: the timing of receipts (when you receive your money) is just as important as the amount you receive.

As a result, because it was deemed necessary to consider money in terms of time value, mathematical procedures known as discounting and compounding were developed, and for that reason real estate analysts use the internal rate of return and the value of money. net present as measures of a property return.

discount

Discounting is the mathematical procedure for determining “present value.”

For example, suppose we are faced with the dilemma of trying to decide between taking one amount today (say, $400,000) or waiting a year to get another amount (say, $430,000). It’s probably safe to say that we would choose the most financially valuable option for us today. But how do we know?

To make that determination, we would mathematically “discount” the future value (ie, the $430,000) by a “discount rate” over a one-year period to calculate its present value, and then simply see if that amount is more or less. less than $400,000.

Okay, but that raises another question. What discount rate should we use in our calculation?

The discount rate is arbitrary to the analyst, and therefore can be any return we select, such as an inflation rate, a rate that can be charged on a CD account, or a rate deemed necessary solely because we have to wait. the money or take the risk.

For example, suppose you decide that if you have to wait a year to get your money, you want it to return 10% for the added risk of dealing with the unknown. In that case, you set the discount rate to 10% and therefore discount the $430,000 by that rate for one year to find its present value. The result is $390,909.09. In other words, next year’s $430,000 will not earn a 10% return, and its present value discounted at 10% provides less purchasing power than the cash you can grab today. So you take the $400,000.

compound

Compounding is the mathematical procedure for determining “future value” and is practically the opposite of discounting.

In this case, we would compound the present value of an asset at a “compound rate” over time to calculate its future value. Consider a savings account. You put a certain amount of money into an account today to increase that amount with (compound) interest to redeem tomorrow.

Let’s say you are given the opportunity to invest $400,000 for a year in a real estate project with the promise that your investment will return 8.75%. Good, but you want to know how much you will raise next year to plan another investment. You would solve for the future value by “compounding” the present value ($400,000) at 8.75% for one year. The result is $435,000.

conclusion

Obviously, the time value of money is not an easy thing to do and requires the use of a financial calculator, spreadsheet, or real estate investment software program. However, it is crucial for a prudent real estate investment. Rental property consists of incremental cash flows collected over time and therefore warrants an effort to understand and resolve.

In the end, your ability to measure the time value of money can be the difference between making a good or bad investment decision. Mathematical solutions for the time value of money would not exist and would surely not be used by successful real estate investors otherwise.