The process of converting future sums
into present value. Discounting is one of
two common techniques used by practitioners
to analyze yield realized on a real estate
investment. The other measure is
compounding. In concert, these represent the
foundation for assessing the time value of
money. In real estate most emphasis is
placed on discounting given the frequent
need to compare and/or value investment
properties based on forecasted cash flows.
As most real estate investment decisions
centre on the anticipation of future
benefits (cash flows), today’s value of
those future benefits is crucial to value
estimates, property comparisons, and
rational decision-making. Most investments
involve the payment of an initial cash
outlay with the anticipation of future
periodic payments (e.g., operations cash
flow through the collection of rent and
payment of expenses), followed by the
disposition of the property (sale proceeds).
Real estate investment analysis involves
both forms of cash flow. For example, a
practitioner can calculate yield if the
present value of an investment is known and
the net operating income for successive
months/years is forecasted along with the
ultimate proceeds from disposition
(reversion). Alternatively, if an investor
requires a specific rate of return, future
cash flows can be discounted at that rate to
provide indications of present value.
Discounting involves three different
types of calculations with compounding
adding a further three. In combination,
these calculations are referred to as the
six functions of a dollar . Discounting
calculations are:
Present value of a future amount
(e.g., the present value of $1,000
received two years from now).
Present value of a series of future
equal payments (e.g., the present value
of 12 payments of $100.00 received over
12 months).
Payment required to amortize an
amount (e.g., the payment required to
repay a loan of $1,000 borrowed at 8% in
four equal monthly payments).
Fortunately, with the arrival of
calculators and computer software programs,
traditional tables setting out discounting
values for these three functions are
virtually obsolete.
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