Why Understanding the Present Value of a Future Cash Flow is Crucial to Real Estate Analysis

Present Value Concerns Time Value of Money

Understanding the concept of present value is essential for any sound investment real cash flow analysis because it might (and often does) ultimately lead to an investment property decision.

So if you are engaged in real estate investing then this one's for you.

Because in this article we are going to discuss present value and how this time value of money concept can play a major role in your next real estate investment decision.

What is Present Value?

The idea is straightforward.

The concept is that the money you might collect in a year or two from a rental property will not have the same purchasing power as it would today due to the annual rate of inflation, which over time, eats away at the purchasing power of the dollar.

As a real estate investor, then, time value of money is essential for you to consider.

Consequently, you would want to calculate the present value of a future cash flow (or series of cash flows) to establish the cash flow an income-producing property generates in today's dollars. This way you can determine what that property is worth to you today.

Discount Rate

The present value of a future cash flow utilizes a discount rate to compute the worth of those dollars to today’s dollars.

Think of it this way.

Rather than adding value to (say) money placed in a savings account with compound interest over several years, discounting reverses the process. That is, it reduces the value of money you might collect in the next several years at a given discount rate to figure out its current worth.

Here's a good rule of thumb.

When choosing an appropriate discount rate for calculating present value of a future cash flow 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?" In other words, "What else is competing for my investment dollar, and what does it return?"

The Formula

PV = FV/(1 + r)n

Where r is the rate per period and n is the number of periods.

Okay, 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 rental property you believe can be sold at the end of five years for $700,000. You decide that your desired rate of return is 11.0% per year and want to know what the property is worth to you today so you can determine what price you should pay for the rental property in order to achieve your desired rate of return.

Here's what you do.

Solve for the present value of the future value anticipated in x-number of years by discounting that future value using your desired rate of return as the discount rate.

In this case, the future value is $700,000, the number of years is five, the discount rate (your desired rate of return) is 11.0% per year, and the result is $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.

As a real estate investor you can see why present value should be of keen interest.

However, it is not a calculation that can be run in your head. In this case, you can consider using Excel, or better yet, a good real estate analysis software or real estate calculator solution that includes computations for present value and other time value of money returns.

About the Author

James Kobzeff is a real estate professional and the owner/developer of ProAPOD - leading real estate investment software solutions since 2000. Create cash flow, rates of return, and profitability analysis on rental property at your fingertips in minutes! Learn more at www.proapod.com

ProAPOD also provides iCalculator - an online real estate calculator that enables you to learn dozens of real estate definitions and formulas as you calculate. You save 64%. Learn more at real estate calculator

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Comments 13 comments

manilenio profile image

manilenio 5 years ago from Manila, Philippines

excellent article! I've recently gone into real estate and would love to learn how to advise potential buyers about the present value of a property to help them decide if the property is right for them. Can you write more about how to come to an accurate discount rate and economic life of a property to come up with a more accurate present value amount? thanks!


James Kobzeff 5 years ago

Hi, Manilento

As a new agent you might find my software helpful. Please visit www.proapod.com I also have more articles on that site under Learning Center. Thank you for your comment.


Luke 5 years ago

Hi i am confused. i am doing an assignment that is asking me to calculate the PV and NPV of an investment property that is worth $480,000 and hope to sell for $575,000 in 3 years time. I am given a discount rate of 7.5% (this includes the 7.2% for the property loan) and cash flows of 20665 year 1, 21307 year 2 and 21862 year 3. The initial investment was $130,000 leaving a loan of $350,000.

I have read many of your articles on the web which explain things well but if i use the pv formula above i get a high number over 466749 but if i calculate the PV as part of a NPV calculation it works out different as I am discounting the cashflows and adding the sales proceeds of 225,000 after repaying the loan.

Is there 2 different ways of calculating this or if someone asks you what is the present value of my property, do you just give them the formula you have mentioned above?


jamesrk profile image

jamesrk 5 years ago from Salem, Oregon Author

Hi Luke,

The total of all your future cash flows is $638,834

The PV @ 7.5% is $518,111

The NPV deducts your original investment (130,000) from the PV. The result for NPV, therefore, is $388,111

Follow http://www.proapod.com/real_estate_calculator_edu. to see a calculator that can help you make and learn these types of computations.


Luke 5 years ago

Hi James,

thanks for the quick reply. I had that PV number calculated but I got confused because I read an ezine article you wrote which said you need to use the sale proceeds (less "outstanding loan balances") in my calcs except the whole $575000 from the sale of the property.


Taleb80 profile image

Taleb80 5 years ago

Mr. Jamesrk

Thank you for this informative Hub.

I am an accountant, I wrote a hub about calculating real rate when you take loans using MS Excel.

I am sure you will find it useful for improving your real estate investment.

(Car Loans – Take Care – Accounting POV focusing on the interest RATE – MS Excel)

You can also add the expected dates & amounts of the rent revenue (Monthly, yearly), so you can have a better investment decision.

I voted "Useful"

Thanks


Trsmd profile image

Trsmd 5 years ago from India

IS THERE any change in the value of money for yesterday, today and tomorrow?


jamesrk profile image

jamesrk 5 years ago from Salem, Oregon Author

H1, Trsmd

Yes, take the (almost daily) increase in gasoline prices for example.

Yesterday your dollar would have purchased more gasoline than it does today; and undoubtedly your dollar will purchase more gasoline today than it does tomorrow.


Luke 5 years ago

Hi James,

I commented on your page 2 months ago about an assignment I was doing asking to calculate the PV and NPV of an investment property. Your reply that deducting the original investment ($130,000 deposit) from the PV of $518,111 made sense but the examiner has marked me wrong.

On querying this they told me that I must not deduct the loan value from the PV result to get the NPV but should deduct the "initial cash flow, that is the purchase price". With your expertise on the matter are my teachers just clowns when it comes to this subject or is there different ways of interpreting it?

I needed to the go on and calculate the IRR which from my original calcs gives me an IRR of 75% which sounds a little high but it was also marked incorrect.

Are you able to see where I went wrong?


salimaa 4 years ago

hi can i just ask is net cash flow same as turnover?

Thank you


permjit 4 years ago

Hi

I need your help to calculate the Pv of future minimum leaase payments over no of years( 5 where rate of intresrt is 3 %.....in which future payments are given like this..

1 1st yr 2000

2nd year 1200

3rd year 850

4th and thereafter 3200

Total 10000/-

How we can calculate present value in this case each year

till 1oth year


jamesrk profile image

jamesrk 4 years ago from Salem, Oregon Author

I'm not quite sure what you mean by net cash flow, but the answer is No.


jamesrk profile image

jamesrk 4 years ago from Salem, Oregon Author

You can use Excel's PV function. Structure it this way for each year. -PV(rate/100, nper, pmt, fv), or (using your first year amount) -PV(3/100,1,0,2000). The result is $1,941.75

You can do it easier, though, with my real estate calculator. See it at http://www.proapod.com/real_estate_calculator.asp

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