Here is a business proposal for you. I am willing to contribute $100,000 to help you invest in a multifamily property. But the catch is, you must wait seven years to receive the money. My question to you; wait seven years or receive $100,000 now? The answer should be pretty straight-forward, you need the money now to invest. Seven years from now, your investment requires might have changed. The $100,000 may or may not be as important. You can do more with the money now, then in the future.
The previous business proposal demonstrates the concept of present value and the time value of money. Money that is available to you today is more valuable than money in the future when purchasing investment properties. Another form of money to consider in regards to rental property is cash flow. The cash flow from a property 3 or 4 years from now is not as valuable as the cash flow today. Today's cash flow can be used in purchase more rental properties now. 3 or 4 years in the future will subject that cash flow to the rate of inflation, thereby reducing its purchasing power.
Simply put, present value is what a dollar received in the future is worth in today's dollar. This is where the ideal of "time value of money" comes into play. In purchasing multifamily or rental properties, the value of your investment money is affected by when it is available or the "time".
When investing in income properties, the question to be answered is; will the property cash flow? Cash flow is money in the future. Therefore, the question is now transformed into; what is the present value of future cash flows? This answer will help you determine the value of the property in today's dollars. In order to do this, you need a way of converting future values into today's value.
A discount rate is the factor that will convert future cash flow dollars into today's dollar values. You will need to decide what discount rate to use. The best rate would be one that is comparable to the rate of return you would expect from other investments with similar risk factors. If you did not invest in a rental property, what other investment could you invest in? This other investment would have a certain rate of return. That rate of return would be your discount rate to use for future cash flows of the rental property.
The get the present value of future cash flows, we need a formula. The formula is:
PV = FV/(1 + r)n
PV is the Present Value, FV is the Future Value, the rate per period is r and the number of periods is n. I would not want to calculate this by hand. Thank goodness, Microsoft Excel has a Present Value (PV) function where you can enter the numbers and the value is automatically calculated.
For a simple example, assume that we want the present value of a single cash flow that you would receive at the end of four years. Consider an apartment that could sell for $1,250,000 at the end of four years. The desired rate of return of this property will be 12.0% per year. What would be the appropriate sales price in today's dollars in order to have a 12.0% rate of return?
The future value is $1,250,000, the number of years is 4 and the discount rate is 12.0%. Solving for the present value gives us a price of $794,398 (rounded), in today's dollars.
Think of it this way, purchase the apartment for $794,398 and after four years you sell it for $1,250,000 you will earn a rate of return of 12.0% per year. It is to your advance as a real estate agent or investor to understand and use the time value of money, present value and other key financial returns. Using Excel, a real estate calculator or a comprehensive rental property analysis software product will make these and other financial ratios and calculations much easier.
