The analysis of a real estate investment calls for an understanding of the time value of money. Primarily because real estate investors are aware that possessing $100 right now is preferable to acquiring that same amount of money in one or more years due to the fact that inflation erodes purchasing power over time.
The significance of time value of money can be illustrated this way.
Imagine that you just won a $1,000,000 lottery and will be paid in equal $50,000 payments over the next 20 years. If each future payment is reduced 8% annually the present value of your twentieth payment is worth just $11,586; the sum total of all your winnings after the 20 years has a present worth of about $530,180.
So it is with the value of money collected over time-its power to buy things becomes less and less as time goes by. Fair enough.
So let’s consider the basic concepts and definitions behind time value of money.
Present Value The value or worth (today) of a cash flow or series of cash flows that will be available at a specified time or times in the future. For example, our lottery winnings have a present value of $1,000,000.
Future Value The future value or worth (tomorrow) is what a cash flow or series of cash flows will be worth at a specified time in the future. In this case we saw that the sum total of our lottery winnings, when collected over the twenty-years, have a future value of $530,180.
Compounding This is the mathematical procedure for determining future value. When money is placed in an interest-bearing account, for instance, it is compounded by some rate that grows it to a larger amount up to some specified time in the future.
Discounting This is the mathematical procedure for determining present value. In this case, we saw that the final $50,000 payment we collect in 20 years, when discounted back annually at a rate of 8.0%, has a present value of just $11,586.
Annuity This concerns a series of equal cash flows made at equal time intervals. The $50,000 lottery payment we collect each year for each of the next twenty years, for example thanks to our good fortune, would be an annuity. It would not qualify as such if it were varying amounts of cash or at irregular intervals.
Annuity Due This constitutes a series of uniform cash flows that are made at equal intervals with the payment being made at the beginning of each interval.
If we collect a $50,000 payment immediately along with a payment at the beginning of each future year, for instance, then our winnings would fall in this category.
Ordinary Annuity This constitutes a series of uniform cash flows that are made at equal intervals with the payment being made at the end of each interval. In this case, say we don’t collect our first $50,000 payment for twelve months and each of our other payments every twelve months thereafter. Then our winnings would meet this category.
Why is this difference in annuity important? Because in the former category we would have $50,000 in hand immediately and would collect our final payment in 19 years; whereas with the latter category, we would not collect our final payment until 20 years later. Obviously, the sooner we collect the money, the higher its present value due to the time value of money, so annuity due would work in our favor.
You get the idea.
Investments in real estate must always be studied with an eye on the time value of money. For as far as real estate investors are concerned, it is highly likely that the timing of cash flows collected from the investment will be more important than the amount received due to the time value of money.