The present value of a future cash flow (or series of cash flows) is calculated when you want to figure out what an income-producing property is worth to you today. After all, producing cash flows is a major part of what income properties do. Each year they generate cash flow (hopefully), and when sold generate one last big cash flow (again, hopefully). But money collected in a year or two will not have the same purchasing power it has today (a concept called the time value of money), so it’s important for a real estate investor to consider the worth of a property’s anticipated future cash flows in today’s dollars at some given rate of return (i.e., discount rate). 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 property you believe can be sold at the end of five years for $700,000. You decide on a discount rate of 11.0% per year (your desired rate of return) and want to know what the property is worth to you today (i.e., what price you should pay to get your desired rate of return). You solve by calculating the present value of the future value (i.e., $700,000) over a time period of five years at the discount rate of 11.0% per year, and then determine a present value of $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.

How to Calculate

• Formula: PV = FV/(1 + r)ⁿ
• Where r is the rate per period and n is the number of periods.

Okay, but let’s face it, we’re not mathematicians, and probably will never make the calculation manually. A more reasonable alternative would be to use Excel, or better yet, either ProAPOD TVM Calculator Software (if you want to make mortgage and time value of money calculations) or ProAPOD Real Estate Investment Software 7.0 (if you want time value of money calculations included with full rental income property analysis).

A Word About Discount Rate

A good rule of thumb to use when choosing an appropriate discount rate for calculating present value of a future cash 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?”

We’ll discuss more about time value of money next time. Stay tuned.

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.

Compared to most returns and measures we use for evaluating income-producing investments, calculating price, income, and expenses per unit is a virtual no-brainer. Merely take a property’s price, gross scheduled income, or total operating expenses and divide it by the number of rentable units. The results aren’t particularly powerful, nonetheless some real estate investors and brokers do use this approach, so it’s a good idea that you know about it.

• Price per Unit. Offers a “quick-read” on newly-listed properties. For example, suppose apartment buildings in your area have been selling for about $50,000 per unit and you see one just listed at $40,000 per unit. Wouldn’t you want to know more? Of course. Because this newly-listed property (for whatever reason you’re not yet aware of) at least has the appearance of a good deal and justifies a call for more information immediately. Whereas, if priced at $70,000 per unit, not the same sense of urgency. So in ten seconds you’ve made a preliminary decision about a property with nothing more than its price and number of units.
• Income per Unit. Probably too vague to be of much use as a “quick read.” For example, if Property A has 30 units with a gross scheduled income of $360,000, then its income is $12,000 per unit. If Property B has 30 units with a gross scheduled income of $270,000, then its income is $9,000 per unit. But without knowing the unit configuration (i.e., studio, one bedroom, two bedroom, etc.) there’s no explanation for the disparity between income-to-units and would require more follow up.
  
• Expenses per Unit. Some real estate investors stand by this number when they evaluate income property. For example, one investor objected to operating expenses of less than $2,500 per unit and was adament on using that figure to calculate the price he was willing to pay for a property. Of course it depends on the individual investor (expenses of $2,500 per unit are not the rule, nor are all investors as proactive about the expenses), still, it’s a good idea to learn what expense per unit typically runs in your area just to keep pro forma numbers “honest.” For example, if Property C is reporting expenses of $1,500 per unit, when you know expenses in your area typically run $2,000 to 2,500 per unit, you’ll be better prepared to question whether those expenses being reported contain an omission or are just pie-in-the-sky.