photo credit: b-randy
Project, Forecast, Predict, Estimate, Magic Eight Ball… there are many ways to tackle a value in the future, but in terms of financial analysis, Future Value is the gold standard (gold is now trading at $1507/oz, so we must assume it’s valuable). As an Analyst in the world of Commercial Real Estate modeling, I can’t begin to explain how important understanding this concept really is.
And honestly, it’s crazy easy!
Future Value is the value of a series of cash flows at a specified date in the future that is equivalent in value to a specified sum today.
Formula: PV * (1+ir) ^ t, where ‘PV’ is Present Value, ‘ir’ is the interest rate, and t is the number of compounding periods (usually years/months from now).
As you’ve imagine, the future value of an asset is a powerful tool in determining the overall value of an asset. It’s of utmost importance to understand (or at least try to) the future operations of a property! Why?
Here is a great example of Future Value relating to Commercial Real Estate. Let’s say we’ve got a development project planned, with the highest and best use being an apartment building. Knowing this project is at least three years from delivery, for financial modeling purposes,we’ll need to project rents three years in the future.
To do so we’ll apply a compounding interest rate to today’s rents (present value), assume monthly rents of $1,000, and 3% compounding interest (3% used as inflation) 3 years from now.
Future Value = 1,000 * (1+3%) ^ 3 = $1,093
Big deal, $93?!? While that $93 might not seem like a big deal, the difference of analyzing a project with $1,000 vs. $1,093 in rent is the difference between moving forward and pulling the plug. That $93 is essential in understand the true reversion value.
For arguments sake this project has 200 units… Follow me.
200 Units * $93 * 12 = $223,200 in additional annual income. We’ll capitalize the $223,200 at 7% = $3,188,571 in straight up bona fide value. The $93 is really $3,188,571, and like I said, the difference between moving forward and pulling the plug.
We’ve supplied you with a very handy Excel Spreadsheet to crystallize this concept. Play with it, we encourage you, and master the future beyond fortune telling (honestly, the fortune telling is in the assumptions, but that’s another lesson).