REAL ESTATE

REAL ESTATE PRINCIPLES

TIME VALUE OF MONEY

REAL ESTATE

Time Value of Money

You are going to lend $100,000 to somebody.
1 year later, how much do you expect to get back?

$100,000
Today

$100,000 ?
$110,000 ?

1 year later

REAL ESTATE

Time Value of Money

You won $100,000 in the lottery today.
1. Which do you prefer?
$100,000

Or

$100,000 ?
1 year later

Today

2. How about this option?

$100,000
Today

Or

$110,000 ?
1 year later
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REAL ESTATE

Liquidity Preference and Return

People prefer present cash flow to future cash flow
Why?
Investment opportunity: You can increase your wealth by
investing the money today
Inflation: Purchasing power may decrease
Uncertainty: Future is uncertain and your future cash flow
may not be realized
Your borrower may disappear
Lottery company may go out of business in six months after you
won

REAL ESTATE

Liquidity Preference and Return

People demand a return for the risks involved in
future cash flows
Ex) Bank gives you a 1% return on the money you
keep in your savings account
Ex2) Bank charges you 5% interest on a loan you took
out to purchase your car

REAL ESTATE

Time Value of Money

We want compare
Present cash flows and future cash flows
Our investment options

Tools
1. Future Value(FV)
2. Present Value(PV)
3. Net Present Value(NPV)
4. Internal Rate of Return(IRR)

REAL ESTATE

Time Value of Money

You are going to lend $100,000 to somebody.
1 year later, how much do you expect to get back?

$100,000
Today

$100,000 ?
$110,000 ?

1 year later

REAL ESTATE

Time Value of Money

You won $100,000 in the lottery today.
1. Which do you prefer?
$100,000

Or

$100,000 ?
1 year later

Today

2. How about this option?

$100,000
Today

Or

$110,000 ?
1 year later
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REAL ESTATE

Time Value of Money

You placed $1,000 in a savings account at your bank.
1 year later, how much do you expect to get back?

$1,000
Today

$1,000 ?
$1,100 ?

1 year later

REAL ESTATE

Future Value

You placed $1,000 into your savings account

Interest rate is 1% per year
How much do you get one year later?
$1,010
How?
$1,000 x 1% = $10
interest

$1,000
principal

$1,010
FV(Future Value)

Or
$1,000 x (1 + 1%) = $1,000 x (1 + 0.01) = $1,010

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REAL ESTATE

Future Value
Principal:
PV = $1,000
Interest rate: r = 1%
FV = 1,000(1+0.01)

1 year

PV = -1,000
FV = 1,000(1+0.01)(1+0.01)

=1,000(1+0.01)2

2 year

PV = -1,000
FV = 1,000(1+0.01)(1+0.01)(1+0.01)

=1,000(1+0.01)3

3 year

PV = -1,000

FV = 1,000(1+0.01)(1+0.01)(1+0.01)

=1,000(1+0.01)n

n year

n-1

PV = -1,000
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REAL ESTATE

Future Value
= (1 + )
where

FV : Future value
PV : Input at time 0
r : interest rate
n : number of periods

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REAL ESTATE

Future Value
= (1 + )
Example
If you save $24,000 at a 1% interest rate today, how much will
this grow to in 6 years?
Ans.)
PV = 24,000, r = 0.01, n = 6
FV = 24,000(1+0.01)6 = $25,476

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REAL ESTATE

Present Value
You will receive $1,100 from your investment one
year later.
You are able to earn 10% per year return from
another investment
How much is $1,100 one-year-later worth, if you
convert it into todays value (present value)?

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REAL ESTATE

Present Value
The answer is $1,000.
How can we calculate it?
If you invest PV , you will earn 10% return in a year.
And your FV is $1,100
Thus, FV = $1,100 = PV x (1+0.1)

Reverse procedure of FV(Discount)

PV

$1,100
1 + 0.1

= $1,000

Discount
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REAL ESTATE

Present Value
Future Cash Flow:
FV = $1,000
Discount rate: r = 10%
FV = 1,000

1 year

PV = 1,000/(1+0.1)
FV = 1,000

2 year

PV = 1,000/[(1+0.1)(1+0.1)]

= 1,000/(1+0.1)2

3 year

FV = 1,000
2

PV = 1,000/[(1+0.1)(1+0.1)(1+0.1)]

= 1,000/(1+0.1)3

n year

FV = 1,000
2

n-1

PV = 1,000/[(1+0.1)(1+0.1)(1+0.1)(1+0.1)]

= 1,000/(1+0.1)n
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REAL ESTATE

Present Value
FV
PV =
(1 + r)n
where
PV : Present Value
FV : Outcome at time n
r : discount(interest) rate
= opportunity cost
= required return
n : number of periods

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REAL ESTATE

Present Value
FV
PV =
(1 + r)n
Example
If your investment opportunity will give you $50,000 in 6 years,
how much are you willing to pay today? You are able to earn 10%
return on other investment.
Ans.)
FV = 50,000, r = 0.1, n = 6
PV = 50,000/(1+0.1)6 = $28,224

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REAL ESTATE

Net Present Value(NPV)

Return of an investment (project) in $ amount, today.

=
Example
If you invest $35,000 today you will receive $7,800 in year 1,
$6,500 in year 2, $11,000 in year 3, $9,988 in year 4 and
$12,000 in year 5. What is the todays value of this investment?
Your discount rate is 5%.

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REAL ESTATE

Net Present Value(NPV)

7,800

6,500

11,000

9,998

12,000

-35,000
7,429 = 7,800/(1+0.05)
5,896 = 6,500/(1+0.05)2
9,502 = 11,000/(1+0.05)3
8,217 = 9,998/(1+0.05)4
9,402 = 12,000/(1+0.05)5
5,446 = NPV

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REAL ESTATE

Net Present Value(NPV): Negative case

7,800

6,500

5,000

3,000

12,000

-35,000
7,429 = 7,800/(1+0.05)
5,896 = 6,500/(1+0.05)2
4,319 = 5,000/(1+0.05)3
2,468 = 3,000/(1+0.05)4
9,402 = 12,000/(1+0.05)5
-5,486 = NPV

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REAL ESTATE

Net Present Value(NPV)

=

General Investment Decision Rules(Not exactly correct)

Only one investment

NPV > 0, then invest
Multiple investment options
Invest at max NPV project.

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REAL ESTATE

PV of annuity
Net present value of constant cash flows
$500 payment every year for 5 years. Interest rate is 5%
500

500

500

500

500

476= 500/(1+0.05)
454= 500/(1+0.05)2
432= 500/(1+0.05)3
411= 500/(1+0.05)4
392= 500/(1+0.05)5

2,165= PV of annuity
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REAL ESTATE

PV of annuity
Net present value of constant cash flows

PMT

PMT

PMT

PMT

1 1/(1 + )
=

1 1/(1 + )

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REAL ESTATE

Internal Rate of Return(IRR)

Annual return of an investment (project) in %, today.

=
=0

=0

(1 + )

IRR
Discount rate which makes NPV = 0 or
At this discount rate, your investment returns you $0.

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REAL ESTATE

Internal Rate of Return(IRR)

7,800

6,500

11,000

9,998

12,000

-35,000

NPV @ Discount Rate = 5%

NPV = $5,446

NPV @ Discount Rate = 15%

NPV = - $4,393

NPV @ Discount Rate = 10%

NPV = $0

IRR = 10%
?
This investment gives you 10% return.
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REAL ESTATE

Internal Rate of Return(IRR)

-20,000

-15,000

10,000

15,100

20,000

-10,000

IRR = 0.09%
This investment gives you 0.09% return.

Will you invest?

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REAL ESTATE

Internal Rate of Return(IRR)

General Investment Decision Rule
IRR > your required return, then invest

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REAL ESTATE

Time Value of Money(TVM)

= (1 + )
FV
PV =
(1 + r)n
1 1/(1 + )
=

1 1/(1 + )

=
=0

=0

(1 + )

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REAL ESTATE

Time Value of Money (TVM)

TVM function in Calculator
Your Mortgage
Interest rate : 5% and
N: 30 years
$250,000 = Loan Amount

Payments..
0

$16,263

$16,263

$16,263

20

$16,263

Remaining balance = $125,572

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REAL ESTATE

Time Value of Money(TVM)

TVM function in Calculator
Interest rate : r %
PV

Payments..
0

PMT

PMT

PMT

PV = f( r, n, PMT, FV)

PMT

FV

Give calculator 4 of 5 elements of TVM and it will calculate

5th element for you.
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REAL ESTATE

End of Lecture 6

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