The Present Value of a Future Cash Flow - Why Understanding Present Value is Crucial To Any Real Estate Analysis

Understanding the concept of present value is essential for any sound investment real cash flow analysis that might (and could) ultimately lead to an investment decision.

So if you are engaged in real estate investing then this one's for you because we are going to discuss present value and how this time value of money concept can play a major role in your next real estate investment decision.

What is Present Value?

The idea is straightforward,

The concept is that the money you might collect in a year or two from a rental property will not have the same purchasing power as it would today (undoubtedly due to inflation). Therefore, due to a concept known as the time value of money, the revenues you might expect to collect from a rental property in future years might be meager when compared to today's dollars, and therefore not worth as much as you think they are.

Consequently, you would want to calculate the present value of a future cash flow (or series of cash flows) to establish the cash flow an income-producing property generates in today's dollars so you can determine what that property is worth to you today.

Discount Rate

The present value of a future cash flow utilizes a discount rate to compute the worth of those dollars to today’s dollars. Think of it this way. Rather than adding value to (say) money placed in a savings account with compound interest over several years, discounting reverses the process.

That is, it reduces the value of money you might collect in the next several years at a given discount rate to figure out its current worth.

A good rule of thumb to use when choosing an appropriate discount rate for calculating present value of a future cash flow would be for you to answer the question, "What rate of return could I reasonably expect to achieve by investing the same amount of money in a similar investment with comparable risk?" Put another way: "What else is competing for my investment dollar, and what does it return?"

The Formula

PV = FV/(1 + r)n

Where r is the rate per period and n is the number of periods.

Okay, let's consider a simplified example that ignores annual cash flow and deals only with the present worth of the single cash flow you expect to collect when the property is sold.

Assume you're looking at a rental property you believe can be sold at the end of five years for $700,000. You decide that your desired rate of return is 11.0% per year and want to know what the property is worth to you today. Namely, you want to know what price you should pay for the rental property in order to achieve your desired rate of return.

Here's what you do.

Solve for the present value of the future value anticipated in x-number of years by discounting that future value using your desired rate of return as the discount rate.

In this case, the future value is $700,000, the number of years is five, and the discount rate is 11.0% per year. The result is $415,416 (rounded). In other words, if you purchase the property for no more than $415,416 and are able to sell it in five years for $700,000, you will earn a rate of return of 11.0% per year.

As a real estate investor present value should be of keen interest. However, it is not a calculation that can be run in your head. In this case, you can consider using Excel, or better yet, a good real estate analysis software or real estate calculator solution that includes computations for present value and other time value of money returns.

James Kobzeff is a real estate professional and the owner/developer of ProAPOD - affordable real estate investment software solutions that do include time value of money and present value computations.