What Investors Need to Understand About Time Value of Money

It should go without saying that real estate investors purchase rental income property to make money, which mostly takes the form of annual cash flows produced by the property along with a profit once the income property is sold.

The wisest investors, however, understand that the timing of those money receipts might be more important than the amount received. That's why time value of money is crucial to real estate investment analysis, and explains why we try so desperately to measure and solve for those changes. Internal rate of return, net present value, and financial management rate of return for example are all used to measure an investor's rate of return with a consideration for the time value money.

It is beyond the scope of this article to discuss more then the rudimentary elements of TVM, but if you are new to real estate investing, with little to no experience, then this article on the subject will prove helpful.

Time value of money is the concept of measuring the value of money over time and is needful because money never remains static and over time changes value.

Stashing $10,000 under a mattress until next year, for instance, will be dramatically affected by time value and you might not like it. Inflation alone can rob you from enjoying the same purchasing power with that fistful of dollars next year as you would today.

There are two components to time value, present value and future value, plus one procedure intrinsic to each, discounting and compounding.

Present Value

Present value defines what a dollar is worth today. If you are able to purchase a duplex today for $400,000 it can be said that $400,000 has the present value (or power to purchase) one duplex. That sum of money in our hands today has the "purchasing power" equal to one duplex.

Future Value

Future value defines the worth of a dollar at some future time. Say we stash our money for one year and find that a duplex now costs $440,000. What do we discover about our $400,000 nest egg? That it no longer has the purchasing power to buy a duplex. In effect, time has devalued our money.

This relationship between present and future value is why some very bright people concluded that the mathematical procedures known as discounting and compounding were necessary to consider money from a time value standpoint.

Discounting

Discounting is the mathematical procedure for determining present value. If given the choice to collect $400,000 today or wait a year and collect $430,000, for example, we would need to discount the future value ($430,000) by some rate (known as the discount rate) for the period of one year to compute its present value.

Since our dilemma is to decide on the amount we can collect today or waiting one year to collect another amount we need to know which amount is worth more to us today. We know that the amount we could collect today is worth $400,000, so what we need to know is what next year's amount of $430,000 is worth today and then make a comparison.

To do that (i.e., compute its present value) we must discount the future value of $430,000 by a discount rate. This rate is arbitrary to the analyst and can be any yield that the analyst selects. It can be an inflation rate, rate that might be collected in a CD account, or a rate deemed necessary solely for having to wait for the money or taking the risk.

Say, for example, that we decide on a 10% discount rate (remember that this rate is arbitrary so it can be any rate we feel would justify the one-year wait). Therefore, we would discount the $430,000 at 10% for one year to compute its present value. The result would be $390,909.09.

In other words, after discounting at 10%, we discover that waiting one year to collect $430,000 would result in less of today's dollars and hence provide us less purchasing power than the option of taking $400,000 today.

Compounding

Compounding is the mathematical procedure for determining future value and is virtually the reverse of discounting. In this case, we want to determine the future value of our money, and we do this by compounding.

Say we are given the opportunity to invest $400,000 for one year with the promise that we would get a yield of 8.75% and we want to determine how much we will collect next year. Here we would solve for future value by compounding the present value ($400,000) at 8.75% for one year and the result is $435,000.

How to Make the Calculation

Time value of money calculations is not practical without the use of a financial calculator, spreadsheet software, or a real estate investment software solution that includes time value of money calculations. It is, however, crucial to prudent real estate investing and therefore justifies any effort you make to understand it and any investment you make to solve for it.

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

James Kobzeff is the developer of ProAPOD - leading real estate agent software solutions since 2000. Work with rental property today. Create APODs, proformas, and other rental property analysis presentations in minutes. Time value calculations made automatically! Learn more at => www.proapod.com

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