Time Value of Money 101 - What Real Estate Investors Need to Know About Their Money

Time value of money is the conception of measurement the value of money over time, because money never stays unchanging and over clip alterations value.

Stashing $10,000 away under a mattress until adjacent year, for instance, will be dramatically affected by clip value and you might not like it. Due to rising prices alone, opportunities are you will not bask the same buying powerfulness with that handful of dollars next twelvemonth as you would today.

That is why clip value of money is important to existent estate investment analysis, and explicates why we seek so desperately to mensurate and work out for those changes.

Internal charge per unit of return, nett present value, and fiscal direction charge per unit of tax tax tax return for illustration are all used to mensurate an investor's charge per unit of return with a consideration for the clip value money.

It is beyond the range of this article to discourse more than then the fundamental elements, but if you are new to existent estate investing, with small to no experience, even a minimum instruction on the topic will turn out helpful.

There are two constituents to clip value: present value and future value. Asset one process intrinsical to each: discounting and compounding. We will try to explicate all four as simply as possible.

Present Value

Present value defines what a dollar is deserving today. If you are able to buy a duplex house house today for $400,000, for instance, it can be said that $400,000 have the present value (or powerfulness to purchase) one duplex. Put another way, that sum of money of money have the "purchasing power" equal to one duplex.

Future Value

Future value defines the worth of a dollar at some hereafter time. Assume that we clip deflection 1 twelvemonth into the hereafter and happen that a duplex house costs $440,000. What make we detect about our nest egg? It no longer have the buying powerfulness to purchase a duplex. In effect, clip have devalued our money.

This human relationship between present and future value is why some very bright people concluded that the timing of gross might be more than of import than the amount received and mathematical processes known as discounting and combination were necessary to see money from a clip value standpoint.

Please make not lose the significance of that conclusion; it is the ground why internal charge per unit of tax return and nett present value are used by existent estate analysts as measurings of a property's profitability. Namely, the timing of gross (when you have your money) is every spot as of import as the amount you receive.

Discounting

Discounting is the mathematical process for determining present value. If given the pick to accumulate $400,000 today or wait a twelvemonth and accumulate $430,000, for example, we would dismiss the hereafter value ($430,000) by some charge per unit (known as the price reduction rate) for the time period of 1 twelvemonth to calculate its present value.

In other words, since we must make up one's mind between getting one amount today or waiting for another amount one twelvemonth from today, our quandary is to make up one's mind which is deserving more than to us today. We cognize that the amount we could accumulate today is deserving $400,000, so what we necessitate to cognize is what adjacent year's amount of $430,000 is deserving today then make a comparison.

To do that (i.e., calculate its present value) we must dismiss the hereafter value of $430,000 by a price reduction rate. This charge per unit is arbitrary to the analyst, and can be any output that that the analyst selects. It can be an rising prices rate, charge per unit that mightiness be collected in a cadmium account, or a charge per unit deemed necessary solely for having to wait for the money or taking the risk.

For example, say we do up one's mind on a price reduction charge per unit of 10% to make the determination discussed above. We would dismiss the $430,000 at 10% for one twelvemonth to calculate present value. The consequence is $390,909.09. Since this amount is less than the amount we can have today, we would make up one's mind to take the $400,000.

Compounding

Compounding is the mathematical process for determining hereafter value and is virtually the contrary of discounting. In this case, we desire to find the hereafter value of our money, and we make this by compounding.

Say, for instance, that we are given the chance to put $400,000 for one twelvemonth with the promise that we would acquire a output of 8.75%. Our quandary is to find how much we will accumulate adjacent year. Here we would work out for future value by combination the present value ($400,000) at 8.75% for one year. The consequence is $435,000.

Clearly, clip value of money is not easy material and makes necessitate the usage of a fiscal calculating machine or spreadsheet software system program. It is, however, important to prudent existent estate investing because rental place dwells of increases of hard cash flowings collected over clip and therefore warrants an attempt to understand and work out for it.

Truly, your ability to mensurate clip value of money can be the difference between your devising a good or bad investment decision. Mathematical solutions for clip value of money would not be otherwise, and surely not used by successful existent estate investors.