This is my first post on BP and I am excited to dive in. Thanks in advance to anyone who reads this or replies.
I've been reading Frank Gallinelli's book What Every Real Estate Investor Needs to Know About Cash Flow, and I have a slightly technical question that I thought I'd put out to this community.
In this book, he talks quite a lot about money having a time element to its value, therefore, he reasons, in future projections, it becomes useful to discount money you will receive in the future to determine its 'Present Value' (PV). Future money is discounted by the rate of return you could expect to earn on that money had you been free to invest it elsewhere TODAY. My confusion is this: if you only have a certain amount of money to invest, why would it be assumed that you could invest that money or its gains elsewhere in the meantime, therefore netting another return, therefore justifying the discount of dollars received in the future? It's not like you can invest the same money in multiple places, and it's additionally very rare that you can get an immediate payout on an investment, so why would we discount future money by the rate of return, when there seems to be no reasonable scenario where we could actually have that money today, or any sooner at all?
I'm sure I've made my point about as clear as mud. I'll give a quick example from the book. If you were to receive $21,000 of profit in year 5 of an investment, the PV of that money, when it is discounted at 11%, is $12,462. But unless there is some magical way to actually have that $21k in hand at the beginning of year 1, rather than in year 5, why would assume that we might have been able to make a return on that money in the intervening years, when in order to make a return on it, it would have to be OURS, but in order to be ours, we (as investors) have to wait for our investment to earn that return?
Many thanks everyone! Glad to be part of this community, I will be participating more beginning TODAY!
@David Sienema , it seems you are thinking about it backwards. Often times in real estate you are trying to determine what a purchase price of an asset SHOULD be, based on its future cashflows and potential profit. The discount rate is the return you would LIKE to see. In your examples this is the 11%. If you want to have $21k in 5 years, and you can earn 11%, then you need $12,462 today.
Again, it is looking at what is your end goal and what kind of returns can you earn during that period of time, to figure out what you NEED to hit that goal.
I have not read Frank Gallinelli's book, but in reality, I can't think of a time that I have used a Present Value formula specifically in real estate investing. But, it is a general concept that should be understood and filters into more common real estate metrics, specifically Internal Rate of Return, which is the discount rate of future cash flows to bring the Net Present Value to Zero. If you don't start to understand PV, then knowing NPV, and then ultimately IRR becomes very challenging.
@Evan Polaski Thanks for your reply! I agree completely with and understand what you are saying. In this book, however, he is talking about how to view the future value of money and how to conduct a discount calculation to determine its present value. He says, "the longer you have to wait for a particular return, the more severely it has to be discounted and the less it is worth. A dollar received in 10 years is far less valuable than a dollar received in one year. You find the PV of each cash flow according to the length of time you must wait for it."
It makes sense that a dollar today is worth more than a dollar in 10 years, but in these calculations, it seems that he is assuming that you actually can have that dollar today, and I don't quite understand why that assumption is made.
Sounds great...as long as you can predict the future. Just look at the past, and tell me if you can. Using analysis like this isn't investing, it's speculating, and is commonly used as an analysis tool in REI when you have a bad deal...and want to rationalize it into a good one.
@Evan Polaski after re-reading this chapter in the book while keeping your comment in mind, it makes perfect sense now. You are correct, I was looking at it wrong. I was looking at the PV calculations in isolation, when he was actually presenting them as a step on the way to NPV and IRR. Thanks for your help!
Hi @David Sienema -
Greetings here from the perpetrator of the book that you’ve been reading. Without getting too deep into the math weeds, permit to elaborate.
As you know, when you consider purchasing an investment property, you are really purchasing a future income stream, with each bit of income occurring at a different point in the future and in a different amount. Your first, and most logical concern will be, how much is that future stream of income worth (in other words, how much should I pay for it) if I expect to make an x% profit for my trouble?
It’s not really worth the total face amount of those future income events (let’s call them by their proper name — cash flows). It’s worth less than that because if you had received all of that money at once, today, then you could have gone out and invested it all and made more money with it. But you didn’t get it all today, so that’s the reason for discounting the value of each of the expected future cash flows — and indeed that’s why this process has always been called “discounted cash flow analysis.” A return deferred is a return less valuable.
BTW, you’re on to something when you point out that you couldn’t necessarily reinvest a small cash flow at the same rate as what the overall property earns. That’s why there is a reinvestment rate variable for those who use Modified Internal Rate of Return as part of their investment analysis. But that’s a chapter for another day ;)
Hi, wow thank you so much for taking the time to answer my question! Your book has been a huge help to me in understanding a lot of concepts and for that I am definitely grateful. I also respect how you made this material, which could so easily be very dull and academic, actually incredibly readable and accessible.
Your answer, however, brought me right back to the original reason for my question. You said, “if you had received all of that money at once, today, then you could have gone out and invested it all and made more money with it.” But what reason is there to think that you could actually have that money today to reinvest and make more money with? If you don’t have the money yet, you don’t have the money, so I’m struggling to see where the opportunity cost is for something that you don’t have and - in the case of the profits, at least - have never had. Unless you have identified some other investment stream that could net you immediate returns (in which case, surely, you would pick that investment!), then how can you speculate that there is even a chance of having your investment profits any sooner? I mean, $20k is only more valuable for me today than it is in a year if I actually could have it today, right? What am I missing?
Hi @David Sienema -
Thanks for your kind words about my book — and sorry if my answer cast more shadows than light on your question. Permit me to try again.
I’m not suggesting that the process of discounted cash flow analysis implies that you actually receive future earnings in hand today. Rather, the DCF is a process you can use to estimate the value of an asset and potentially compare it to a competing opportunity.
Think of it this way: The stream of future cash flows is an asset, same as any other tangible asset you might buy, like a Tesla or a Rembrandt. How do you decide how much you are willing to pay for it? Fortunately, it’s a bit more straightforward with a piece of income-producing real estate than it is with an Old Master. The asset you’re buying is a series of future cash flows — including the proceeds of the resale at the end of your holding period, which is your final cash flow in this series — but the value to you is not the sum of their face values. Rather, it’s the sum of their discounted values, discounted at rate that you would consider to be a suitable rate of return for a successful investment.
So if you calculate that the discounted value of the projected future cash flows from this property — say each value is discounted at 10% per year — equals $20,000, then you would be willing to spend $20,000 to purchase that asset because you would then expect to get a 10% return on your investment.
It doesn’t mean that purchasing the property is going to put $20k in your hand today, day one. It does suggest that you have cash available today to invest, presumably $20k (remember, investing means you have skin in the game), and you expect to receive an income stream in return for that investment at a rate of return acceptable to you.
In short, the DCF process is a method of valuation, and it’s a decision-making process. Is the discounted income stream going to be worth the price you pay for it? If not, DCF is telling you that you would probably want to take your money elsewhere.
Thank God for questions and conversations like these. Can we have more of these and less "should I open an LLC...... well it depends on your goals" threads.