The Time Value of Money (TVM) is an important factor when analyzing commercial real estate opportunities for investment. The TVM is the idea that money in hand is worth more than money given or earned in the future. For example, if someone were given the option between $5.00 today or $5.20 a year from now, one would most likely ask for the $5.00. Why? Because if they were to take the $5.00 and pick an investment with a modest five percent annual return, they would have $5.25 a year from now.
While the TVM is a basic factor when analyzing real estate, it is the building block on which an investor can measure project and investment profitability. Many real estate investments are viewed as mid-term to long-term investments, and the TVM becomes increasingly important in these situations as an investor tries to gauge whether an investment’s future earning potential justifies the risk of its initial cash outlay.
Since the cash flows earned from an investment in future years are worth less than cash at the present, these cash flows must be ‘discounted’ at the minimum return rate a real estate investor is willing to take when looking at an investment or competing investments. This rate, called the Discount Rate, helps an investor measure an investment’s Net Present Value (NPV).
If the present value of these future cash flows (the NPV) exceeds the present value of the initial cash outlay, this means that the investment’s return will exceed the investor’s minimum acceptable return rate (oftentimes called the investor’s ‘hurdle rate’) and that the investment is acceptable. Illustrated below are two $100 investments that both net the same overall cash flow of $24.00 and demonstrate the importance of the TVM concept and how the discount rate and NPV factor into the analysis of real estate.
Both investments cash flow the same amount of money over the same period of time, but Investment A has a positive net present value when both cash flows are discounted at 12 percent. Why? Because Investment A earns a greater amount of its cash flow earlier on in the investment cycle, while Investment B earns a greater amount of its cash flow later on in the investment cycle, which are discounted more heavily due to the later timing. Investment B’s cash flow pattern actually results in a negative net present value, indicating to the investor that Investment B does not pass the ‘hurdle’ and that the discounted cash flows will not net the minimum 12 percent return over the life of the investment. This scenario demonstrates the power of the TVM.
These financial concepts are crucial when measuring risk in real estate investing. Knowing how these concepts work helps to mitigate one’s risk and make an informed and educated decision on where to deploy capital most efficiently. One should contact their certified accountant when deciding to invest in real estate. For more information on how Black Diamond Realty can help with your search of income-producing properties, call Ryan at 304-413-4350.