5 Key Elements of The Time Value of Money in Real Estate Investing
If you want to be a successful commercial real estate investor, an in-depth knowledge of the time value of money (TVM) is crucial. To understand the concept, let’s consider which is better, $10,000 now or $15,000 ten years from now.
If someone offered to give you $10,000 today or $15,000 in ten years, what would you do? You would take the money now, of course! When you make that decision, your intuition is telling you that the value of $10,000 today is worth more than $15,000 in ten years. That is a fundamental principal of the Time Value of Money. Sooner is better.
Let’s take a closer look. Why is money worth more today than the same amount in the future?
Your intuition can tell you that a lot can happen in ten years. Due to unforeseen circumstances, you may not get all of your money, or any at all. If you are paid today, you have zero risk of not receiving the money.
Because of inflation, $1,000 in the future will probably not be worth what $1,000 is worth today. You can buy more with $1,000 now than you in ten years, because prices for goods and services are likely to go up. Money you have today has a higher purchasing power.
There are a lot of things you can do with your money today to make it grow – like investing in real estate. If you wait ten years to receive your money, you are losing the opportunity to invest.
The Fundamentals of Time Value of Money
- Compounding and Discounting
Compounding and discounting are basic concepts used to understand how time value of money affects real estate investments.
Compounding is figuring out how much an investment you make today will be worth in the future. You might make a lump sum payment, or a series of payments over time. The important point is that your investment grows at a certain rate as it earns interest on the amount invested. You also earn additional interest on the interest.
Discounting is finding out the current value of an amount of money that is set to be received at a future date, whether as a lump sum payment or as a periodic return. You find the current value by applying an opportunity cost or discount rate to the future sum.
- Five Key Elements of Time Value of Money Situations
There are five variables to consider in every time value of money problem. The letter in parentheses represents the symbol used in mathematical calculations. Sometimes you will know four out of the five components, and in that case you will use a formula or financial calculator to figure out the unknown quantity.
1. (n) Periods
Periods are the total number of time phases within the holding time.
2. (i) Rate
The rate is the interest or discount commonly expressed as an annual percentage.
3. (PV) Present Value
The present value represents the amount of a sum of money today.
4. (PMT) Payment
The payment is the amount of money received or paid out equally for each period. Positive payments are payments received, while negative payments are payments made.
5. (FV) Future Value
The future value is a single amount of money that is scheduled to be received or paid out in the future.
Tips for Figuring Out the Time Value of Money
I suggest you pay close attention to consistency when figuring out the time value of money. Be sure that the number of periods, interest rate and payments are expressed in the same way. If the interest rate is an annual rate, the periods and payments should be expressed on an annual basis. Pay attention to positive and negative signs that indicate an inflow of cash or an outflow of cash.
Here is a link to a free online calculator : Free Time Value Calculator