Long Term Wealth Building…The Importance of TVM
If you are looking to build long term wealth with real estate, it is really important for you to understand basic Time Value of Money (TVM) principles.
For example: You receive two offers from other investors on a house you just put under contract to buy with a quick closing this week for $40,000 cash. The house is worth $75,000 and needs no repairs.
Offer #1: $60,000......$20,000 cash to you to assign the contract.
Offer #2: $78,000......$ 8,000 down payment to you and $500/month @5.99% for 241 months (You are out of pocket $32,000 at closing and hold a note for your investor buyer)
Which do you choose?
Let’s see.... $500/mo X 241 months = $120,500 less your $32,000 up front investment = $88,500 in profit
Isn’t $88,500 way better than $20,000? Isn’t it an obvious choice?
Beware! Simply adding up the payments you receive over time completely disregards the time value of money.
Certainly if you have a dire need for $20,000 today, or you don’t have access to $32K cash, you would choose Offer#1, but if you have cash or retirement funds and are looking to build an ongoing income stream, you may choose Offer #2 and hold the note.
How do you evaluate the choices accurately?
That’s where determining the time value of money (TVM) comes in to play. TVM basically means that a dollar received TODAY is worth MORE than a dollar received one day later, or one month later, or years later....because you can put the dollar you receive today TO WORK TO EARN MORE MONEY.
Waiting for the dollar down the road means it won’t be earning you ANYTHING. By waiting, you are giving up the potential earnings of that dollar for the period of time that you wait. In addition, you take on the risk of possibly not receiving those payments on time or ever.
How do you determine how MUCH MORE today’s dollar is worth?
It depends on how MUCH LATER you receive it, and how much you can EARN putting that dollar to work. As you can imagine, this can get pretty confusing. This is where a financial calculator is essential.
I use the HP 10bii app. I have been investing for 19 years and I use it every day. To choose the best offer out of the two choices above you need to determine the Present Value of both offers in TODAY’S DOLLARS. For Offer #1 that is easy: $20,000 today = $20,000 today. But for Offer #2, you need to “discount” the future payments back to today in order to compare them to the $20,000 cash offer. (Determine what next month’s payment of $500 is worth today, then the 2nd months, 3rd, ...., for each of the 241 payments, and add them all together along with the initial $8,000)
Can you imagine how long it would take to figure that out manually for all 241 payments? We are lucky the calculator app can do all this for us. The Present Value answer will be different for different investors.
First, you have to choose a discount rate to enter into the calculator. If you would normally earn 10% on your money, that is the discount rate to use, but if you are an experienced hands-on investor, with many other great deals to sink your cash into, you may not be happy with anything less than 50%.
How do you know what numbers to plug in and where on the calculator?
Using a 10% discount rate, the present value of Offer #2 is: $59,880. Compare this to Offer #1 of $20,000 and you would choose to take Offer #2 because it has a higher present value. You would hold the note. Using a 50% discount rate, the present value for Offer # 2 is: $19,999. This is about the same as Offer #1.
Which would you choose?
You may choose the cash if you have a pending deal to put it into, or the note if you don’t, but the present values are essentially the same assuming you are comfortable with the risk of waiting for payments over time. The $20,000 is “for sure” cash, you know you’ve got it in your hand...The $500/month is “maybe money,” MAYBE they will pay you.
If you know the investor/note payor well, have done deals with them before, or know this can lead to a deal after the deal, keeping the note may also be the best strategy.
If you choose Offer #2, what is your yield assuming you receive every payment on time over the 241 months?
Is it the 5.99% in interest you are collecting on the principal balance of the note? No, your yield is 18% because you only put $32,000 into the deal on the front end.
What would be your yield if the house is sold or refinanced and the note is paid off in three years? It would be 37%. Or, your yield could be infinite if you brought in a money partner to put up the initial $32,000 for a partial ownership of the note.
Even though TVM concepts are important to understand, making the best decisions on real estate investments is NOT only about the numbers.
The quality of the collateral, potential risk and the people involved are also major considerations. Actual yield can only be calculated accurately after all payments are received.
Reprinted Courtesy of Central Florida Realty Investors. Visit www.CFRI.net From the April 2018 issue of the CFRI Newsletter.