Have you ever heard the saying that “a bird in the hand is worth two in the bush?”
Said in a different way, something guaranteed is more valuable than the unknown, and something you have today is worth more than something you will get in the future. This principle also applies directly to the world of real estate development and investing.
Return on Investment
Return on investment is a simple way of measuring the performance of an investment. If I ask you to invest $1.00 with me, you would want to know how your investment will perform. If after investing with me, I return $1.10 to you, your ROI is 10%.
ROI = (Capital Returned – Capital Invested) / (Original Capital Invested)
Example ROI = (1.10 – 1.00) / (1.00) = .1/1 = 10%
Time Value of Money
In the real estate world, the “bird in the hand” principle is called the time value of money. Simply put, a dollar in value in the future is worth less in the future than it is today. How much less? Well, it depends.
An investable dollar is always losing value, either through inflation or opportunity cost.
Inflation
Inflation means that the cost of everything we are trying to buy goes up over time, so we can purchase less of an item in the future than we can purchase today.
Opportunity Cost
We always have a choice of where or how to invest a dollar, many opportunities. Choosing not to invest is also an option, with a return of 0%. The Opportunity Cost is the difference between the choice we make and the best alternative. If we choose not to invest when our alternative is a return of 10%, our opportunity cost is -10%.
If an investable dollar is constantly losing value over time, the most important piece of information needed before making an investment decision is to determine just how much value the dollar is losing.
Risk
When investing you also have to take risk into account. An investment with a guaranteed 2% return – from the US Government or a bank or a trusted friend – should be viewed differently than an investment that is supposed to return 2% but is very risky. A risk adjusted rate of return is a return percentage that has been adjusted based on the level of risk involved in an investment. The higher the risk, the more the rate of return is reduced. Risk adjusted rate of returns allow two investments with different levels of risk to be effectively compared.
Discount Rate
The discount rate is the rate – in percentage form – at which you have determined your investment dollar will lose value if you decide not to invest. Your discount rate could be set to the rate of inflation, your opportunity cost of capital, the interest rate being charged or equity or debt capital you are borrowing, a target rate of return set by your investment committee, or some combination of all of the above. The discount rate is a single number for a given analysis. The discount rate stays the same throughout a given analysis.
If your discount rate is 10%, you are saying that an investment dollar is worth 10% less a year from now than it’s worth today. Said in a different way, someone would need to pay you $1.10 a year from now for you to invest $1.00 with them today. Or, in order to receive a $1.00 return a year from now, you would need to invest $.91 today.
Discounted Cash Flow
Real estate investments are usually long term investments, often evaluated over a 10-year time horizon. The investments grow in value over time, but as described above the future dollars are worth less than present dollars due to the time value of money.
In order to understand and compare investments with future returns against each other you need to conduct a discounted cash flow analysis.
The cash flow of an investment represents the income from an investment over a given period of time minus the expenses for that investment over the same period of time. Analyzing annual, quarterly, or monthly cash flow is most common.
A discounted cash flow analysis simply means that you create a financial model projecting all of the future costs and returns of an investment decision, often over a 10-year investment life. The future cash flow, or the future income in a given year reduced by the future expenses associated with an investment in that same year produces a number that represents the projected annual future cash flow of that investment.
If in year six of an investment the income is $5.00 and the expenses are $3.00, the future cash flow for year six is $2.00. But given the time value of money, we know that $2.00 six years in the future is worth less than $2.00 today. To determine how much the future dollars are worth, we have to conduct a discounted cash flow (DCF) analysis.
In this example let’s assume our discount rate is 10%. The future dollars are discounted by 10% for every year into the future we go. Since we are six years in the future the math is:
$2.00/(1+.10)^6 = $2.00/1.77 = $1.13
In the example above 1.77 is our discount factor for year six.
Therefore the $2.00 return six years from now is worth $1.13 today. If you invest $1.13 today and achieve a 10% annual return for 6 years, you will have $2.00 at the end of the 6 years.
A DCF analysis is simply projecting all your cash flows out into the future and then applying a discount factor for each year. The future returns are worth less than present returns. A bird in the hand is worth two in the bush.
Net Present Value
Net present value (NPV) is an analysis framework used to determine whether or not to make an investment. If an investment is determined to have a positive NPV you should make it, if the NPV is negative you should pass.
Net Present Value is determined by subtracting the initial cash investment amount from the total of all future discounted cash flow numbers from the DCF. The DCF can include positive and negative future returns. In our simplified example above, with one return in year six, the some of future discounted cash flow is $1.13. Since our initial investment was $1.00, the NPV = $1.13 – $1.00 = $.13. The NPV is positive so the investment should be made. If the return cash flow in year six was only $1.50 the DCF would be $1.50/1.77= $.85. Therefore the NPV is $0.85-$1.00= -$.15. You should not make this investment.
When comparing several investment scenarios, the investment with the highest NPV is the one you should make.
Internal Rate of Return
The term internal rate of return, or IRR for short, is another metric used to compare two different investments after the fact. To calculate an IRR the investment or development must have been sold because IRR is a time dependent measurement – the investment must have a beginning and an end – and the investment must be complete so that all cash flows can be accounted for.
I will talk more about IRR in another article, but simply put, the IRR is a calculated rate of return that if applied over the same period of time would have delivered an identical financial performance.
IRR is best calculated in excel or some other financial modeling software
A real estate investment rarely delivers consistent returns year over year so it’s hard to compare one investment to another without a metric like IRR.
Conclusion
The few paragraphs above are not meant to be a replacement for advanced finance finance studies, but are rather meant to give you a glimpse into the terminology of real estate investing.
I hope you now have a better understanding of how various investments are measured and compared, and how a decision to invest – or not to invest – is made. An investor in real estate has a responsibility to their partners to make decisions that result in the best financial outcomes possible, and these calculations and metrics are how those decisions are measured.
Exercises
- Should you make an investment if the NPV is zero?
- Assuming the risk profile and duration of investment are the same, which investment is better performing: An investment with an IRR of 25% or an investment with an IRR of 21.7%?
- Which cash flow is more valuable to an investor, a $45 return in Year 7 or a $45 return in Year 8?
- Can a discounted future cash flow have a negative value?
Next Steps
If you liked this article, I recommend you check out the rest of the Development Jargon series! If you have any questions or comments for me, make sure to drop a comment below.
