Business

Time value of money is the concept of measuring the value of money over time.

Why do we care, because value of money changes with time and it’s crucial to analysis of a real estate investment to be able to measure and solve for those changes.

There are two components.

Present Value

Present value defines what a dollar is worth today.

For instance, if today’s cost for a duplex is $400,000 it can be said that $400,000 has the present value (or power to purchase) one duplex.

Future Value

Future value defines the worth of a dollar at some future time.

If $400,000 can buy a duplex today, suppose the duplex appreciates 10% and next year costs $440,000. What can be said about the future value of our $400,000? Our money is worth 10% less than its present value because next year it will take 10% more dollars to buy the duplex than it does today.


Say we have an investment that gives us the option of collecting $400,000 today or waiting a year to collect $430,000. Which is preferable? We take the $400,000 because next year $430,000 will not buy a duplex and therefore has less purchasing power than $400,000 does today.

Here’s the point: the timing of receipts might be more important than the amount received. This is why the relationship between present and future value must be studied and measured from a time value of money standpoint.

To solve, two mathematical procedures known as discounting and compounding are applied.

Discounting

Discounting is the mathematical procedure for determining present value.

For example, to determine whether we should collect $400,000 today or wait a year, we solve for present value by discounting the future value ($430,000 promised next year) by some rate for the period of one year.

For our computation, we elect to use the inflation rate of 10% as our rate. Therefore, we discount the $430,000 at 10% for one year. The result is $390,909. Since this amount is less than the amount we can receive today, we decide to take the $400,000.

Compounding

Compounding is the mathematical procedure for determining future value.

This is the reverse of discounting. Here we solve for future value by compounding the present value ($400,000) at 10% for one year, which, in this case, results in $440,000. Still, because the investment only pays $430,000, it’s clear our desired return is not achieved. So we opt to cash out.

This is not easy stuff, and requires the use of a financial calculator. But it is crucial, and understanding it can be the difference between making a good or bad investment decision so it is worth the effort.

ProAPOD® Real Estate Investment Software has a Mortgage – Financial Calculator that calculates time value of money solutions in seconds. It mimics the HP 10 but it's easier. Just two or three entries into the user-friendly forms and your results appear instantly.