Imagine for a moment that you have a very generous friend. One day, this friend comes to you and tells you that it’s been a successful year and he or she wants to give you some money. The friend offers two choices: you can have $5,000 today, or you can have $5,000 in two years. Which option would you choose? It is likely that your instinct would be to choose the money today. You don’t know what is going to happen in the future and a sure thing today seems like the right way to go.
At its core, this is the idea behind the time value of money in real estate: X dollars that a commercial property generates today is more valuable than the same amount years in the future.
Time Value of Money – Defined
The Time Value Money (TVM) is a financial concept which states that the value of a dollar today is worth more than a dollar received in the future. Broadly, there are three reasons why this is the case.
The first reason has to do with risk. In the example above, taking the money today is a sure thing. Taking the money in the future carries some level of risk. The friend could lose the money or there could be a falling out that causes the friend to reconsider this offer in two years.
The second reason has to do with inflation, which is the rate at which the prices for goods and services rise. Historically, the inflation rate has been 2% – 3% annually. This means that the $5,000 taken today could be used to purchase more goods and services than in the future. Or, another way to think about it is that the money loses a little bit of “purchasing power” each year due to inflation.
The third reason has to do with opportunity cost, which is the forgone benefit that would have been realized from an option not chosen. There is an opportunity cost to taking the money in the future because the money taken today could be reinvested to earn interest so that it is worth more than $5,000 in two years. In the example above, assume that the individual took the $5,000 right now and invested it into a mutual fund that earned an interest rate of 8% annually. At the end of year one, they would have $5,400 ($5,000 * 1.08). At the end of year two they would have $5,832 ($5,400 * 1.08). This $832 dollars in interest is the forgone benefit from the choice of taking the $5,000 in the future.
The time value of money concept is useful when evaluating a capital budgeting or purchase decision across a number of different asset classes, particularly those that produce a regular series of cash flows like a bond, annuity, or commercial property.
Importance of Time Value of Money in Commercial Real Estate Investment?
To illustrate the importance of time value of money in commercial real estate, it can be helpful to think about the property as representing a series of cash flows.
Fundamentally, a commercial real estate investment is the exchange of a lump sum amount of money today (the purchase price) for a series of periodic future cash flows. However, the challenge for many commercial real estate investors is that this concept works in reverse. In order to determine a reasonable purchase price, investors need to determine the present value of the cash flows that are expected to be received in the future. This is a process known as “discounting.” To illustrate how this works, an example is helpful.
Suppose that an investor is considering the purchase of a small retail shopping center. This investor plans to hold it for 5 years and then sell it for $125,000. As part of the due diligence, the investor has reviewed all of the leases and historical operating statements for the property, and uses this information to create a pro forma, which in turn is used to estimate the amount of cash flow received from the property annually. It looks like this:
Year 1: $8,000
Year 2: $9,000
Year 3: $9,500
Year 4: $10,000
Year 5: $135,000 ($10,000 Operating Income + $125,000
So, the question for real estate investors is, how much should they pay for a property that produces this series of cash flows? To answer this, the cash flows need to be discounted back to the present time.
Overview of Discounted Cash Flow (DCF) Analysis
In order to solve the time value of money problem above, investors need to use a discounted cash flow analysis. This includes five variables:
- Number of Periods: The total number of discounting or compounding periods in the anticipated holding period. In the example, the number of years is 5.
- Discount Rate: The annual interest rate that the investor expects to earn on their investment. The choice of a discount rate is somewhat subjective and dependent upon each individual investor’s return requirements. For the sake of this example, assume that the rate of return is 8%.
- Present Value: The single sum of money today. In a CRE context, it is the purchase price. In the example, it is $100,000.
- Cash Flows: The periodic amount of money that is expected to be received each period.
- Future Value: The sum of money to be received in the future. In the example, it is the expected sales price of $125,000.
With the variables identified, the investor can solve for the potential purchase price by determining the net present value (NPV) of the estimated cash flows. Rather than go through the complex math to calculate it, it is easier to calculate it using the “NPV” function in a spreadsheet program or a financial calculator. The result is $121,894.
Another way to look at this result is that the investor should pay this price if they want to earn an 8% annual return on investment on the projected cash flows. However, it is important to note that this value can change dramatically based on the investor’s annual return requirement, estimated cash flows, and sales price. This should not be viewed as the price that should be paid, but as one data point in the property valuation exercise.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.