<--Back to Wiki Home
Present Value of $1:
In real estate, the present value of $1 refers to the current value of a future payment of $1, after accounting for inflation and the time value of money. It's a tool used to calculate the present value of future cash flows, such as rental income, over the life of an investment property.
Let's say that you have the option to receive $1,000 either today or in five years. If you choose to receive the money in five years, it will be worth less due to the impact of inflation and the time value of money. To determine the present value of the future $1,000, you would need to use the present value of $1 table, which shows the present value of a future payment of $1 at different interest rates and time periods.
"A Deep Dive for Real Estate Agents and Appraisers"
Here is a more detailed working example of this:
Imagine you want to buy a property to rent out and make money for 10 years. You think it will make $10,000 each year from renters. You need to know how much all that money is worth today to see if buying the property is a smart choice.
To figure this out, you use something called the present value of $1 table. This table helps you find out how much a dollar in the future is worth right now, based on different interest rates and time periods.
First, pick an interest rate. Let's say you want to make at least 6% profit on your investment. This 6% is called the discount rate.
Next, use the present value of $1 table to find a number called the present value factor for each year of the 10 years. This number tells you how much a dollar at the end of each year is worth today. For example, if the present value factor for year 1 is 0.9434, that means $1 at the end of year 1 is worth 0.9434 today.
Now, multiply the $10,000 rent money you expect each year by the present value factor for each year. For year 1, the present value would be $9,434 (10,000 x 0.9434).
Do this for all 10 years, and then add up the present values for each year to find the total present value of all the money you'll make over 10 years. In this example, the total present value for the 10-year period would be $77,764.
By finding the "present value" of the money you'll make from renting the property, you can decide if it's a good investment. If the property's price is less than $77,764, it might be a smart choice since that's the value of the money you expect to make in the future, but in today's dollars.
A present value is different from a future value because money today is worth more than the same amount of money in the future. This is mainly because of two reasons:
Inflation: Over time, the prices of goods and services tend to rise, which means the purchasing power of money decreases. For example, if you have $100 today, you can buy more things with it than if you had $100 several years from now, since the prices of things might be higher in the future.
Opportunity cost: When you have money today, you have the option to invest it and make more money over time. If you receive the same amount of money in the future, you lose the chance to invest it and earn additional income. For example, if you have $100 today, you can invest it and earn interest, which could grow to more than $100 in the future.
Because of these reasons, the present value of money is different from its future value. Present value helps you understand how much a certain amount of money in the future is worth today, taking into account the impact of inflation and the potential returns you could earn from investing that money. In other words, present value helps you compare the value of money received at different times by converting future amounts to their equivalent value today. This is important when making financial decisions, such as investing in a property or a business, where you need to consider the timing of cash flows and the time value of money.
The concept of present value is related to the time value of money, which is the central idea behind the "Six Functions of a Dollar". The six functions of a dollar are fundamental financial calculations used in finance, accounting, and economics to evaluate investments, loans, and other financial decisions. They are:
Future Value of $1 (FV): If you put a dollar in a bank account or investment that earns interest, how much will it grow to in the future?
Present Value of $1 (PV): If you will receive a dollar in the future, how much is it worth today, considering that money today can be used or invested to make more money?
Future Value of an Ordinary Annuity of $1 (FVoa): If you save a dollar every month (or other regular period) in an account that earns interest, how much will you have in total in the future?
Present Value of an Ordinary Annuity of $1 (PVoA): If you will receive a dollar every month in the future, how much is that stream of money worth today?
Future Value of an Annuity Due of $1 (FVad): This is similar to FVoa, but the dollar is saved at the beginning of each period rather than the end, so it earns a little more interest.
Present Value of an Annuity Due of $1 (PVad): This is similar to PVoA, but the dollar is received at the beginning of each period rather than the end.
These six functions of a dollar are related to the time value of money, which is the idea that a dollar today is worth more than a dollar in the future due to inflation and the opportunity to earn interest on investments. By understanding these functions, you can make informed financial decisions, such as evaluating the worth of investments, loans, and other financial transactions, taking into account the timing of cash flows and the time value of money.
"Wit & Whimsy with the Dumb Ox: Unlocking Knowledge with Rhyme:"
Present value of $1, oh what a chore,
It's a tool to calculate the worth of future more.
It's the current value of a future buck,
After accounting for time and inflation's muck.
Imagine you have a choice to receive,
$1,000 in the future or now, oh what a reprieve!
But if you wait, the money's worth will decline,
Due to inflation and the time value's incline.
To determine the present value of the money, oh gee,
You need to use the table, it's easy as can be!
It shows the present value of a future payment of $1,
At different interest rates and time periods, it's all done.
So when you know the interest rate and time,
You can use the table, it's no crime!
To calculate the present value of the future sum,
And you'll know what the money's worth, oh what fun!
So remember this, my friend, it's clear,
Present value of $1 helps you compare,
Different options and investment decisions too,
It's a useful tool, that's true!