The Time Value of Money is essential for understanding risk and returns
Despite what the Rolling Stones may tell you, time is not on your side. Money, risk, and opportunity all change over time and it's essential to understand how time affects your investments.
The Time Value of Money (TVM) is an important concept in commercial real estate investing because it allows you to take into account the fact that a dollar received in the future, is not worth a dollar received today. Why is that?
There's risk associated with waiting to get dollars back in the future. If I have to wait for my money to come back to me, is there a chance it couldn't? Or is there a chance that the amount of money I thought I was getting could be different?
Inflation. As dollars inflate over time due to increasing demand, you have less purchasing power in the future. This needs to be accounted for.
The last has to do with the fact that if my money is tied up in an investment, I don't have access to those dollars (and the interest) until it's returned back to me. This is called "opportunity cost."
In essence we are going to wrap up the fact that there's risk, devaluation, and lost opportunities into a discount rate to compensate us for this. We want to take all of those future cashflows, apply a discount rate, and then determine what we should pay for an investment in today's dollars. This is called the "Present Value" in an investment.
The calculator I will be using can be found here and is a great tool to evaluate: https://www.calculatestuff.com/financial/npv-calculator. NPV stands for "Net Present Value" however and I will show you how that works below.
If we look at an investment that returns $10,000 /per year over 5 years and apply a 9% discount rate, we can see that the initial investment should be $38,896.51, which is the Present Value. We know exactly what those future cashflows in today's dollars are worth to me.
Net Present Value uses a discount rate and applies it to an initial investment and tells you how much you can under- or over-pay for an investment. Let's use a commercial real estate example. Let's say a broker sends you an offering memorandum and you are considering purchasing. Here are the details:
Asking price: $6,250,000
First year NOI: $385,000 (w/3% annual increases)
Anticipate selling at the end of year 5 at a 6.5% capitalization rate
If we apply a 9% discount rate to the above scenario, it should look something like this:
Having a negative NPV number implies that we would be overpaying by $205,226.99 if we were to purchase this property at asking using our 9% discount rate. You may be asking why year 5 is such a high number. It's because it adds in our increased cashflow that was growing at 3% along with our reversion price (sale) at the end of the year. Here's how we get it:
Year 4 NOI + 3% increase = $433,321
In order to get year 5 reversion, you take Year 6 NOI, which means you have to increase another 3%.
Year 5 NOI + 3% increase = $446,321
$446,321 / 0.065 = $6,866,471
$446,321 + $6,866,471 = $7,312,792
Discount rates mean different things to different investors, however they usually imply risk. The higher the risk, the higher the discount rate needs to be in order to compensate. Make sure you understand these concepts and how they apply to underwriting an investment property.
About the author:
Michael Hironimus, CCIM is the Certified Investment Advisor and Principal Broker for Duckridge Realty Advisors specializing in portfolio and asset management for high net worth clients and institutions. He is also a faculty instructor for the CCIM Institute, teaching professionals globally in the CI-102 Market Analysis Core Course.
For more information, reach out to michael@duckridgerealty.com.