Real Estate and note investors make decisions by projecting financial outcomes over time. These time-based projections require the investor to have an understanding of future value and present discount value.
Since these projections can maximize returns and reduce risk, it’s necessary for an investor to understand these concepts and how to apply and calculate them.
This mini-lesson will outline the time value of money by definition and then display a short drill down using a financial calculator.
In the note buying business, we deal with people and numbers. Some of the numbers we have to calculate are things like yield and present value. Present value is a concept that comes out of the time value of money concept. This short video is going to go through the definitions of what time value of money is and then get right into some calculations to show you how we come up with these numbers. First of all, the time value of money is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.
All right, what the heck does that all mean? First of all, let’s start with something pretty simple, future value. Most people understand future value. Future value is the value of an asset at a specific date. For example, if you are proposed with this question, what is the future value of investing $500 per month for the next 12 months with an annualized interest return of 10%? To calculate that, you can use a financial calculator like I have on your screen here. You can see on this financial calculator that I’ve entered the data here, it’s going to be 12 payments. That’s going to be one payment per month at 10% interest and the payments are $500 per month. What I’m going to do is solve for the future value or FV.
On these financial calculators all I have to do is click on that button and it tells me that the future value of investing $500 per month for 12 months at a 10% return is $6,282. That’s it. Pretty simple concept, pretty easy to understand. The answer to the question, what is the future value of investing $500 per month for 12 months with an annual interest rate of 10% and the answer is $6,282. Now, in the note buying business we deal with the present value. Present value, also known as present discounted value is the value of an expected income stream determined as of the date of valuation. Here’s what that means. What would I pay today for an income stream of $500 per month for 12 months if I needed or required a 10% annualized return?
Once again, I can go back to my financial calculator here and enter the data. Once again I’ve got 12 payments, one payment per month 10% interest, $500 per month and what I’m going to do now is solve for the PV or present value. On a click of a button it tells me that the answer is $5,687. Again, what that means is if I invested $5,687 today and in return I receive $500 per month for the next 12 months I would be making a 10% annualized return. The answer once again is what would I pay today for an income stream of $500 per month for 12 months if I needed a 10% annualized return and the answer would be $5,687. Now, in the note buying business, we typically buy much longer periods of time.
In the example I’m showing you here we’ve looked at 12 months but what if you’re post with this question, what is a $100,000 note at 8% interest for 360 months with the monthly payment of $733 worth today if I need or require a 10% annualized return? Okay, back to our financial calculator here I’ve entered the data. A $100,000 note written at 8% interest for 360 months means the payments are 700 just over $733 per month. I’ll just round it to 733. Now, if I’m going to buy this income stream and to buy this I want to get a 10% return, what I can’t do is I can’t just buy this note and then call the borrower and say, “Those payments are $733 a month.” I’m going to have to bulk those up. I can’t do that. I’m buying the note as it was created.
For me to effectively get a higher return, I would have to simply recalculate what my present value would be. If I change the entry to say 10% per year is my required return and then I resolve for the present value. The calculator tells me that $83,613 is the answer. Let me reinterpret it. If I invested $83,613 today and in return I receive $733 per month for 360 months I would be making 10% annually on my money, what we call the yield in the business. I would be making a 10% yield. That $100,000 note for me is worth $83,612 today.
Hope you enjoyed this mini lesson on calculating present value and understanding a little bit about time value of money.