Before delving into real estate, learn discounting

September 18, 2010 

The most important concept for real estate investing, or any investing, is this: Investing is essentially buying a future stream of income. To invest well, you need to know how to evaluate and compare future streams of money.

A future stream of money, or cash flow, has three attributes to consider when comparing investments: quality, durability and quantity.

Quality refers to strength of the source of money you will receive from the investment. In real estate, this means the tenant's ability to pay the rent. A lease with Exxon has a higher quality than a lease with the local pizza shop.

Durability means how the cash flow will endure over time. A warehouse building that almost anyone can use will have less vacancy and higher durability than a special use building, which is suitable for limited uses and will have longer vacancies between tenants.

Comparing the quantity of a future cash flow is problematic for real estate. Cash flows are different for every property, because of different purchase prices, down payments, annual cash flows and future sales prices. Fortunately, anyone with a home computer and a financial program such as Excel can easily complete an analysis to provide the needed comparison.

But first you have to understand the concept of determining what a future income stream is worth today. This is called "discounting" and is based on the "time value of money."

Start with the most basic idea: Money received today can be invested and grow. For example, $100 received today invested at 5 percent will grow to $105 in one year and to $110.25 in two years. Determining what today's money is worth in the future is called compounding; future money is called future value.

Because money can grow over time, the sooner you receive money, the sooner you can invest and begin its growth, and as a result, the more money you will have in the future.

Discounting is the most important concept to understand. Go back to the example above. The $105 we have a year from now, which was invested at 5 percent interest, is worth $100 today. Stop and think about this: The value today, called the present value, is the amount of money you have to invest today to have it grow to the amount of money to be received in the future.

In discounting, money received sooner has a higher present value than money received later. In the above example, if the $105 was not received for two years instead of one year, the present value would be $95.24. That is, $95.24 invested at 5 percent grows to $105 in two years. With more time, less money is invested to achieve the same future value. So, money received later is worth less today than the same amount received sooner.

The interest rate is the other major component of discounting. The interest rate used in discounting is called the discount rate and is the interest rate at which you can invest. Remember, interest is the compensation for risk -- the higher the risk, the higher the interest rate; the lower the risk, the lower the interest rate.

Say an investment you are considering has more risk than the 5 percent rate used in the example above, and you have to get a 7 percent return. At 7 percent -- the $105 future value in one year has a present value of $98.13. You invest less with a higher interest rate to get $105 in one year. In this example, you can invest $98.13 at 7 percent interest instead of $100 at 5 percent to get $105 in one year. The higher the discount rate, the higher the risk and the lower the present value.

While these numbers can be confusing, all you have to remember is -- more sooner is better.


Chris Stephens, CCIM, is a local associate broker specializing in commercial and investment real estate. His opinion column appears every month in the Anchorage Daily News.

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