What Makes Time Value of Money Crucial to Investors?

06:50 2008

Discover the meaning, importance, and components of time value of money. Learn why time value is crucial to prudent real estate investing analysis.

Real estate investing is about the numbers. Cash flow, rates of return, property value, financing, and a few dozen other ratios and measures are no better or worse than the bottom line.

Understanding that bottom line correctly, however, must involve 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 straightforward. Because money never remains static and over time changes value, it must be measured against time.

For example, if you stash \$10,000 away under a mattress until next year, you might be disappointed to discover that due to inflation alone you won't enjoy the same purchasing power with that fistful of dollars next year as you would today. Time erodes the value of money.

That's why time value of money is crucial to real estate investment analysis, and explains why we desperately try to measure and solve for those changes. Returns such as internal rate of return (IRR) and net present value (NPV) are commonly used to measure a real estate investor's rate of return with a consideration for time value money.

Of course, it's beyond the scope of this article to discuss more then the rudimentary elements of time value of money. But if you're new to real estate investing, perhaps with little to no experience, then even a minimal teaching on the subject will prove helpful. We'll consider four components: present value, future value, discounting, and compounding.

Present Value

Present value defines what a dollar is worth today.

For instance, say that you have a \$400,000 cash nest egg and today could purchase a duplex for exactly \$400,000. It can be said then that your \$400,000 has the present value (or power to purchase) one duplex and thus a "purchasing power" equal to one duplex.

Future Value

Future value defines the worth of a dollar at some future time.

Okay, now assume you time warp one year into the future and find that a duplex costs \$440,000. What do you discover about your nest egg? Time has devalued it. Whereas, \$400,000 does provide the purchasing power to buy a duplex today, tomorrow it doesn't.

For this reason, because this relationship between present and future value does exist, it caused some very bright people to conclude 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 every bit as important as the amount you receive.

As a result, because it was deemed necessary to consider money from a time value standpoint, mathematical procedures known as discounting and compounding were developed, and for that reason internal rate of return and net present value are used by real estate analysts as measurements of a property's profitability.

Discounting

Discounting is the mathematical procedure for determining "present value".

For example, assume we have the dilemma of trying to decide between taking one amount today (say, \$400,000) or waiting one year to get another amount (say, \$430,000). It's probably safe to conclude that we would choose the option financially worth more to us today. But how do we know?

To make that determination we would mathematically "discount" the future value (i.e., the \$430,000) by a "discount rate" over the period of one year in order to compute its present value and then simply look to see whether that amount is more or less than \$400,000.

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

The discount rate is arbitrary to the analyst. Therefore it can be any yield we want to select, such as an inflation rate, rate we might collect in a bank account, or a rate deemed necessary solely for having to wait for the money or taking the risk.

Suppose, for example, that you decide it best not to endure the risk of waiting for your money unless it yields at least 10%. In that case, you establish the discount rate at 10% and hence discount the \$430,000 by that rate for one year to compute its present value. The result is \$390,909.09. In other words, next year's \$430,000 will not yield 10% return and its present value discounted at 10% provides less purchasing power then the cash you can take today. So you take the \$400,000.

Compounding

Compounding is the mathematical procedure for determining "future value" and is virtually the reverse of discounting.

In this case, the present value of an asset would be compounded at a "compounding rate" over time to calculate its future value. Consider a savings account. You place a certain amount of money today into an account in order to increase that amount with (compound) interest for redemption tomorrow.

Say that you're given the opportunity to invest \$400,000 for one year in a real estate project with the promise that your investment will yield 8.75%. Fine, but you want to know how much you'll be collecting next year in order to plan for another investment. You would solve for future value by "compounding" the present value (\$400,000) at 8.75% for one year. The result is \$435,000.

Conclusion

Time value of money is obviously not easy stuff and does require the use of a financial calculator, spreadsheet, or real estate investment software program. It is, however, crucial to prudent real estate investing. Rental income property consists of increments of cash flows collected over time and therefore justifies every effort for us to understand and solve for it.

In the end, 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 surely not used by successful real estate investors otherwise.

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