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 and when sold generate one last big cash flow (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.

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, a good financial calculator software program like ProAPOD.

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?"