The idea is fairly straightforward.
Money collected in a year or two will not have the same purchasing power it has today due to the time value of money. That is, over time the value of money erodes, and therefore cannot be expected to purchase the same amount of goods and services in the future as it does today.
As a result, real estate investors must consider present value in order to solve the question, “What is a real estate investment worth to me today based upon the present worth of its future cash flows?”
PV might be easiest understood as the reverse of compound interest. Money deposited in a bank today, for instance, grows over time to some greater amount in the future because it is “compounding” at a specified interest rate. Whereas, PV would “discount” that future amount at the specified interest rate to arrive at the amount deposited today.
Here’s how it works for the purpose of our discussion.
- The real estate investor decides upon the desired rate of return he or she wants to earn from the property’s future cash flows
- Those future cash flows are then discounted at that rate of return to determine their present value
- PV = FV/(1 + r)n
- Where r is the rate per period and n is the number of periods.
As a simplified illustration, let’s assume that you’re looking at a rental income property you believe can be sold at the end of five years for a $700,000 gain. You want to know what price to pay for the property in order for that gain to yield you 11.0% annually.
- $700,000 is the future value (FV)
- 11.0% is the rate per period
- Five years is the number of periods
If you run the calculation, you’ll see that the PV of that future amount is $415,416 (rounded).
In other words, if the investor pays $415,416 or less for the rental property he or she will get their desired rate of return. If they pay more, they will not.
The illustration above hopefully makes the point regarding the importance to real estate investors about calculating PV.
What if, for instance, several different investment opportunities of similar risk were competing for the investor’s investment dollar. He or she would be unable to determine which investment would more likely yield his or her desired rate of return without the present value calculation.
So You Know
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