Calculating the present value of a future cash flow helps a real estate investor solve the question, “What is a real estate investment worth to me today based on its future cash flow?” Defined as “the present value or worth (today) of a cash flow or series of cash flows that will be available at a specified time or times in the future,” present value is best understood by considering what takes place in a savings account.
You place a certain amount of money into an account and by the end of the first year that money has grown because it has earned interest (i.e., rate of return). By the end of the second year the principal and interest combined earn more (compound) interest, and so on. For example, let’s assume you deposit $1,000 into an account earning you 5.0% interest per year. In two years you’ll discover that your initial investment grew to $1,102.50. What took place? Your $1,000 today (present value, PV) became $1,102.50 (future value, FV) over time because present value compounded (was added to) at a rate of 5.0% per year (i.e., the compound rate).
When rental income property appreciates in value over time a similar process takes place. Present value grows to future value (i.e., an available future cash flow). However, to solve for the present value of that future cash flow, instead of compounding (adding to) present value at a given rate of return (as we did with our savings account) and arrive at future value, we reverse the process. We discount (reduce) future value at a given rate of return to arrive at its present value. For example, let’s assume you’re projecting that a particular real estate property will appreciate to $500,000 in five years and want to know what the asset is worth to you today for you to get a rate of return (i.e., discount rate) of 5.0% per year. You would calculate for present value by taking the property’s future value and discounting (reducing it) over those number of years at that given rate of return.
We’ll discuss the present value formula and look at more examples next time. Stay tuned.
