In real estate, the time value of money (TVM) is crucial for investors looking to maximize their returns. Simply put, the principle states that money today has more purchasing power than it will in the future due to inflation and other factors.
Real estate investors aware of the time value of money concept can use it to their advantage by making informed financial decisions that consider factors such as interest rates, cash flow, and the potential for appreciation.
Time Value of Money Basics
Investors who invest their money with future payments and interest-generating accounts may be able to grow their money over time via accruing interest or return on investments. This idea is referred to as future value or FV. The future value is the effect time can have on a dollar and a series of cash flows. There are three primary axioms behind the time value of money theory:
- Opportunity cost: You can invest your money today and begin accruing interest to increase its value.
- Inflation: The value of your dollar could decrease by the time you receive it and invest it.
- Uncertainty: A promise is just a promise until you receive the money. Deals could fall through, and situations can happen where you may never get the money.
When considering the time value of money, two significant factors must be considered: compounding periods and opportunity cost.
Compounding Periods
Compounding is when an asset's earnings from interest or capital gains get reinvested to generate even more profits over time. This occurs because the investment will produce income from the original principal and the accumulated earnings from previous periods as they are reinvested repeatedly.
The number of compounding periods has a significant effect on the TVM calculation.
How Does Opportunity Cost Relate to TVM?
Opportunity cost, as it relates to the time value of money, is the potential return loss when you choose one option over another. Money can only grow if you invest it and earn a positive return. If you don't invest that money, it loses value over time due to inflation. This is why opportunity cost and TVM are important parts of the decision-making process.
Why Is TVM Important for Real Estate Investors?
TVM is an important concept for real estate investors because it affects the potential returns they can earn on their investments over time. Due to factors such as interest rates and inflation, money received or paid at different times has different values. For real estate investors, holding onto capital for too long can result in lost opportunities for potential gains, while investing too quickly or without careful consideration can result in unnecessary risk.
Of course, there are many reasons why a real estate investor may hold money on the sidelines, such as waiting for a particular property to become available, dealing with unexpected expenses, or simply being cautious in uncertain market conditions. However, by holding onto this capital for too long, an investor may be able to avoid missing out on potential gains that could be earned through investing that money elsewhere.
With TVM, the longer an investor waits, the greater the opportunity cost of not investing. For real estate investors, this means that they need to assess the potential risks of investing against the potential losses of holding onto their capital to make informed investment decisions that balance risk and reward effectively. By doing so, they can potentially maximize their returns over time and achieve their investment goals.
Time Value of Money Formula
The most TVM calculation for the time value of money considers the following:
- The present value of money
- The future value of money
- The interest rate
- The number of compounding periods per year
- The number of years
You may need to adjust the TVM formula depending on the situation. Perpetual and annuity payments, for example, may require fewer or additional factors.
Here is the TVM formula from the Corporate Finance Institute:
FV = PV x [1 + (i/n)](n×t)
The components of the formula are as follows:
- FV = future value of money
- PV = present value of money
- i = interest rate
- n = number of compounding periods per yet
- t = number of years
Present Value
The present value (PV) formula calculates the current value of a future sum of money. It considers the time value of money and is based on the principle that money received or paid at different times has different values due to factors such as inflation and interest rates.
The formula uses the future value, the discount rate (or interest rate), and the number of periods until the future value is received to calculate the present value of a future sum of money. The result is the current value of the future sum of money, adjusted for the time value of money.
Net Present Value (NPV)
Net present value (NPV) is a financial calculation used to determine the value of an investment by considering the time value of money. The formula calculates the present value of all cash inflows and outflows associated with a particular investment, discounted to the present day, using an appropriate discount rate.
Here's an example of how it works: imagine an investor considering two different investment opportunities, each requiring a different amount of initial capital and promising a different stream of potential cash flows over time. By calculating the net present value of each investment (i.e., the present value of the expected cash inflows minus the present value of the expected cash outflows), the investor can determine which investment is more likely to be profitable, given the time value of money.
The NPV calculation takes into account both the size and timing of each cash flow, as well as the general level of risk associated with the investment. By comparing the net present value of different investment opportunities, investors can make more informed investment decisions that consider the time value of money, resulting in potentially higher returns and lower risk over time.
Future Value
You can easily rearrange the formula to show the future value of money. Say you invest $15,000 for one year at 10% interest compounded annually. According to the TVM formula, you will end up with future cash of $16,500 by the end of the year.
Example of How To Calculate Time Value of Money
Here is an example of how the time value of money works: Say you won the lottery with a cash prize of $20,000. You can either be fully paid upfront in cash or receive the $20,000 in five years.
To make your dollar worth more in the future than its value today, you would need to calculate the future value. If you have plans to take the $20,000 today and invest it into an account with an annual rate of 5%, you will use this formula to find out its value in five years:
- FV = I x (1+(R x T))
Using this formula, you would plug in the variables below:
- I = investment amount ($20,000)
- R = interest rate (5% or 0.05)
- T = number of years (5)
- $20,000 x {1 + (0.05 x 5)}
- FV = $1,250
This tells you that in 5 years, your $20,000 invested with a 5% annual interest rate will turn into $21,250. Another way of looking at this is that if you waited five years to receive your $20K, your opportunity cost of doing so would be a loss of $1,250.
TVM Calculator With Excel
Calculating TVM manually can be complicated and error-prone. You can make things easier by using electronic spreadsheets such as Excel. Excel has financial functions built into its program to help solve TVM equations. The syntax of the PV function is:
=PV(rate, nper, pmt, [fv], [type])
Here's what each component means:
- rate-interest rate per period
- nper: total # of compounding periods
- pmt: annuity amount per period. If you don't include this, you will need to enter a PV into Excel
- [fv]: future value of the investment (optional)
- [type]: If the annuity is received at the end of the compounding period, enter 0; if the annuity is received at the beginning of the compound period, enter 1 (optional argument, and by default, the value is set to 0)
Using a Financial Calculator
You can also use a financial calculator to solve TMV equations. While each calculator varies, you can typically use the steps below to solve the problem. It is important to know that cash outflows should have a minus sign.
- Understand the problem and what the question is
- Set the calculator to "0"
- Enter the known value
- Enter the # of compounding periods for the year
- Enter the annual interest rate
- Enter the total # of compounding periods
- Find out the unknown
Key Takeaways
Here are some important things to remember about the time value of money (TVM):
- Inflation has a negative effect on the TVM since you can purchase less as prices increase.
- The formula for computing the TVM considers the amount of money, future value, the amount it can earn, and the time frame.
- Compound interest is an important factor for savings accounts.
- The time value of money means that a certain amount is worth more today than receiving that same amount later in the future.
- The main concept of TVM is that investing is the only way to grow the amount; otherwise, it becomes a lost opportunity.
Understanding the concept of the time value of money is important for your finances as it helps you make more informed decisions. TVM can also help budget, analyze loans, and evaluate investment opportunities.
