The analysis of real estate investment requires an understanding of the time value of money. The idea is that inflation erodes purchasing power over time so its probable that the money an investor might collect from a real estate investment – say in three years – will not be able to purchase the same amount of goods and services as it would today.
As a result, investments in real estate are studied from a time value of money standpoint because investors understand that it is equally as important (if not more important) to determine the timing of receipts from the investment as the amount received. This is where the concept of present value comes in.
In this article we will be looking at the present value of a future single amount (not an annuity). That is, what the present value of a lump sum of money specified in the future is worth today after discounting that amount by the real estate investor’s specified discount rate.
About Present Value
- Present value calculates what a cash flow specified at a time in the future is worth in today’s dollars when discounted annually at some rate.
- Discounting is the mathematical procedure for determining present value.
- Discount rate is the rate that future benefits will be discounted to arrive at PV based upon the investor’s desired rate of return.
How to Compute
Say you’re considering an investment expected to be worth $250,000 in 3 years and you want to know how much you should invest to collect that amount and get an annual 15% rate of return on your investment. In this case, the future value is $250,000, the discount rate is 15.0%, the number of periods is 3 years.
To calculate PV it would be best to use a financial calculator like HB10B, Microsoft Excel, or iCalculator. We’ll illustrate the calculation for both Microsoft Excel and iCalculator.
Excel (click image to enlarge)
iCalculator (click image to enlarge)
Based upon your future value and number of time periods you must not invest more than $164,379.06 to get an annual rate of return of 15% on your investment. If you invest more your rate of return will decrease; likewise if you can invest less and still collect the same amount in the future your rate of return will increase.
So You Know
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