Time value of money

Time value of money is the concept of measuring the value of money over time. The concept derived from the fact that money does not remain static and over time does change value.

The money in your wallet, for example, is more likely to buy you more gasoline today than it will next year (perhaps even more than it will tomorrow based on surging oil and gas prices). In other words, due to inflation alone, chances are that you will not enjoy the same purchasing power next year as you would today because over time the value of your money will likely decrease.

Conversely, let's say you purchase a rental property today for $300,000 that's worth $350,000 next year. In this case, the effect of time value of money has upon your investment is a good thing because it grew your investment.

Understanding time value of money, therefore, is crucial to real estate investing, and explains why we try so desperately to measure and solve for those changes with such elements as internal rate of return (IRR) and net present value (NPV). We need to measure an investor's rate of return with consideration for time value money.

Two components are intrinsic to time value: present value and future value.

Present value defines what a dollar is worth today and future value defines the worth of a dollar at some future time. It's straightforward, simply think about it in terms of purchasing power. In our rental property example, for instance, the present value of our $300,000 could purchase that rental property today but not next year. Why, because next year, based on a future value of $350,000, our purchasing power has diminished.

This relationship between present and future value is why some very bright people concluded that real estate investors must consider the timing of receipts from their real estate investments as important (if not more important) than the amount received. That is, due to time value of money, given the opportunity to collect some money within a shorter time could be wiser than collecting a larger sum of money in the distant future.

Let's look at a scenario. Suppose we're given the choice to invest $300,000 in one of two investment opportunities knowing we can collect either (1) $350,000 in one year, or (2) $400,000 in two years. Which yields us the better return on our investment? The answer may surprise you.


$350,000 in one year yields us 16.7%
$400,000 in two years yields us 15.5%

Without consideration for time value of money, a real estate investor might have opted for the larger sum and lost money. This is why the analysis of a real estate investment requires an understanding of the time value of money. Remember the concept. Inflation erodes purchasing power over time and therefore makes having $10 today preferable to having that same amount one year or five years from now. With time value of money computations, you can measure the present value of each and make wiser real estate investment choices.

by James R Kobzeff ,the developer of ProAPOD Real Estate Investment Software