Another term that’s important to get a conceptual grasp of is “net present value.” It’s important to understand this concept because most of your real estate income will come in the future. Therefore, you must know what that income is worth today.
In my real estate courses, I’ve taught that a dollar today is worth more than a dollar tomorrow. This is due to two reasons:
1. Number one is the affect of inflation on the value of a dollar. Inflation decreases the value of your dollar every day. If it takes one dollar today to buy a loaf of bread and in five years it costs two dollars, then the value of your dollar has been cut in half. Therefore, your dollar is worth more right now than it will ever be.
2. The second reason is the idea of risk. There is some level of risk in any investment that you won’t get paid in the future. If you have the dollar in your pocket, there is no risk. You already have it and don’t have to worry about receiving it later.
So, because most of your investment return will happen in the future, it’s important to know what that money is worth right now. Using a financial calculator, you can determine the value of future dollars based on what’s called a “discount rate.” It’s also referred to as a “costs of capital rate” This is merely the interest rate that you think you would make on the money in some other investment if you didn’t put it in this one. For instance, let’s say to buy a property you have to put $10,000 as a down payment. Obviously, you have lost some opportunity with that money. You could have put it in the bank, you could have bought some stock, or some other investment. Your opportunity costs, then, must be determined and put into this equation. This rate, which is enumerated as an interest rate, is entirely based upon your individual circumstances –it’s entirely your opinion or your experience that determines what “discount rate” you will use.