Intro to Real Estate Finance
Crowdfunding real estate investments requires a good grasp of finance and investing, including understanding the business plan and financial model of a given investment opportunity. As with any other industry, strong real estate investors will understand the risks and opportunities associated with the industry, market and financial plan before investing. In fact, real estate is considered to be a multidisciplinary investment field, which requires an understanding construction and maintenance, local economics, demographics and cash flow management. Financial skills are necessary for assessing the financial feasibility of investment opportunities. So in this article we’ll touch on a few key concepts related to real estate finance.
Time Value of Money
A core concept for understanding the value of an investment is the “time value of money” of that investment. For instance, you would need to understand which is more valuable: a note paying $500 per month for ten years or the one that pays $400 for 15 years. All you need is a calculator to find the answer. You need to know how much money you are going to make from the investment; when you will be able to get it and the certainty or percentage of risk in getting it. A million dollars to be received over a period of twenty years is surely not the same as receiving the same million dollars right now.
Future Value of Money
The reason why money received immediately is worth more than one received in installments over a period of time, is due to several factors, such as inflation, risk and opportunity cost. Future money is not assured. There could be any number of incidents that could prevent you from receiving the money, such as recessions and bankruptcy.
The opportunity cost relates to the amount that you lost (or are unable to gain), because your funds were locked up and were not available to invest in other good investments. Funds available today can be invested in deposits, bonds or in stocks that could yield profits. So, in effect, you have the potential to lose out on potential profits.
This is not to say that investors should only seek short term investments. In fact, the opposite is true. Notorious investors such as Warren Buffet often maintain investments for the long term. The key is to understand the impact of time on your investment, so that you can factor that in to your analysis.
Discounted Cash Flow Model
When analyzing a real estate investment, a discounted cash flow (DCF) model is one traditional method for establishing present value. With a DCF model, the investor makes assumptions for cash flow over time, generally expressed in the form of future net operating income (NOI) growth.
In the case of a real estate investments, the primary cash flow components to consider are rental incomes and property management expenses, both of which are likely increase over time. Because the DCF model includes future income and expense growth it is essentially estimating all future cash flows and then discounting that cash to give the present value.
Based on these assumptions, an investor can calculate the internal rate of return along with the net present value of the property. Hence, if the internal rate of return is more than the investor’s required rate of return, the NPV is a positive one and investment is a wise decision in this case.
DCF Example
To better understand DCF, let’s use a simple example…
Jane decides to buy a tract of undeveloped land in an up and coming part of town for $100,000. Because the land is undeveloped and she has no plans to develop it, she expects to have no income or substantial costs. Furthermore, because she knows that a new college campus is being developed just a mile away, she expects the property to appreciate in value to $150,000 in just five years.
Assuming that her assumptions are correct, a simple calculation suggests that the value of her profit on such a transaction would be $150,000 − $100,000 = $50,000, or 50%. And if we amortize the $50,000 over the five year period, her internal rate of return would be about 8%. Depending on a number of other factors, such as local real estate market conditions and the rate of return of competing investments, she might be justified in thinking that the purchase looked like a good idea.
Calculating Net Present Value
One of the financial concepts encountered in real estate is the net present value and the net future value. The net present value or NPV is a measure used in real estate investing for analysis. The NPV informs the investor whether the target rate of return set by him will be achieved by a specific property. This, in turn, will inform him whether it is worth investing his capital in that particular real estate project.
Technically speaking, it is based on the rule stating: the opportunity can be deemed a profitable one if the discounted present value related to future benefits is the same as or more than the cost of such benefits. However, if the present value related to future benefits is below the cost incurred for such benefits, the ROI may not be obtained and the investor needs to think again before investing.
Use of Net Present Value
The NPV is very useful in this case for assessing the value of the proposed investment. It can inform you whether the future cash flows or benefits from an invested property can yield a good return for your capital investment. All you need to do is to take into account the yield that you require or are hoping for. The NPV will do the rest and calculate whether the targeted yield is achieved.
Tools
Some of these concepts may seem esoteric to first time real estate investors. So, I’ve included a spreadsheet of Real Estate Investment Calculators including a simple IRR calculator and NPV calculator, which you can use to run some hypothetical examples of your future real estate investments.
Crowdfunding real estate investments requires a good grasp of finance and investing, including understanding the business plan and financial model of a given investment opportunity. As with any other industry, strong real estate investors will understand the risks and opportunities associated with the industry, market and financial plan before investing. In fact, real estate is considered to be a multidisciplinary investment field, which requires an understanding construction and maintenance, local economics, demographics and cash flow management. Financial skills are necessary for assessing the financial feasibility of investment opportunities. So in this article we’ll touch on a few key concepts related to real estate finance.
Time Value of Money
A core concept for understanding the value of an investment is the “time value of money” of that investment. For instance, you would need to understand which is more valuable: a note paying $500 per month for ten years or the one that pays $400 for 15 years. All you need is a calculator to find the answer. You need to know how much money you are going to make from the investment; when you will be able to get it and the certainty or percentage of risk in getting it. A million dollars to be received over a period of twenty years is surely not the same as receiving the same million dollars right now.
Future Value of Money
The reason why money received immediately is worth more than one received in installments over a period of time, is due to several factors, such as inflation, risk and opportunity cost. Future money is not assured. There could be any number of incidents that could prevent you from receiving the money, such as recessions and bankruptcy.
The opportunity cost relates to the amount that you lost (or are unable to gain), because your funds were locked up and were not available to invest in other good investments. Funds available today can be invested in deposits, bonds or in stocks that could yield profits. So, in effect, you have the potential to lose out on potential profits.
This is not to say that investors should only seek short term investments. In fact, the opposite is true. Notorious investors such as Warren Buffet often maintain investments for the long term. The key is to understand the impact of time on your investment, so that you can factor that in to your analysis.
Discounted Cash Flow Model
When analyzing a real estate investment, a discounted cash flow (DCF) model is one traditional method for establishing present value. With a DCF model, the investor makes assumptions for cash flow over time, generally expressed in the form of future net operating income (NOI) growth.
In the case of a real estate investments, the primary cash flow components to consider are rental incomes and property management expenses, both of which are likely increase over time. Because the DCF model includes future income and expense growth it is essentially estimating all future cash flows and then discounting that cash to give the present value.
Based on these assumptions, an investor can calculate the internal rate of return along with the net present value of the property. Hence, if the internal rate of return is more than the investor’s required rate of return, the NPV is a positive one and investment is a wise decision in this case.
DCF Example
To better understand DCF, let’s use a simple example…
Jane decides to buy a tract of undeveloped land in an up and coming part of town for $100,000. Because the land is undeveloped and she has no plans to develop it, she expects to have no income or substantial costs. Furthermore, because she knows that a new college campus is being developed just a mile away, she expects the property to appreciate in value to $150,000 in just five years.
Assuming that her assumptions are correct, a simple calculation suggests that the value of her profit on such a transaction would be $150,000 − $100,000 = $50,000, or 50%. And if we amortize the $50,000 over the five year period, her internal rate of return would be about 8%. Depending on a number of other factors, such as local real estate market conditions and the rate of return of competing investments, she might be justified in thinking that the purchase looked like a good idea.
Calculating Net Present Value
One of the financial concepts encountered in real estate is the net present value and the net future value. The net present value or NPV is a measure used in real estate investing for analysis. The NPV informs the investor whether the target rate of return set by him will be achieved by a specific property. This, in turn, will inform him whether it is worth investing his capital in that particular real estate project.
Technically speaking, it is based on the rule stating: the opportunity can be deemed a profitable one if the discounted present value related to future benefits is the same as or more than the cost of such benefits. However, if the present value related to future benefits is below the cost incurred for such benefits, the ROI may not be obtained and the investor needs to think again before investing.
Use of Net Present Value
The NPV is very useful in this case for assessing the value of the proposed investment. It can inform you whether the future cash flows or benefits from an invested property can yield a good return for your capital investment. All you need to do is to take into account the yield that you require or are hoping for. The NPV will do the rest and calculate whether the targeted yield is achieved.
Tools
Some of these concepts may seem esoteric to first time real estate investors. So, I’ve included a spreadsheet of Real Estate Investment Calculators including a simple IRR calculator and NPV calculator, which you can use to run some hypothetical examples of your future real estate investments.
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