Photo Credit: andrewinpompey
In any type of investment, from a savings account to a commodities future, it’s important to understand the fundamentals of finance and how it relates to your investment type. The following content may seem elementary to some, Gaelic to others, yet regardless of your level of understanding, this basic information should prove helpful.
The idea of Time Value of Money (TVM) is very simple: money today is worth more than money tomorrow.
So why is this true?
Put your money into a savings account, it’ll make you rich one day. We’ve all heard this; we’ve been encouraged from childhood to save and for obvious reason: we learn responsibility, we practice temperance, we spend our parents’ money instead of our own. And whether we sell lemonade, open a kissing booth, sell our sisters Barbie’s at the yard sale (sorry sis), or wash dishes, at a certain point, we’ve all had an opportunity to showcase our financial prowess and invest some of our well-earned cash into a savings account.
Now that we sit at the “big” table on Thanksgiving, we’ll find ourselves quite wealthy as our savings accumulate over time.
In the not so distant past, savings rates were as high as 5% Annual Percentage Yield (APY), meaning that for every $100 deposited the bank would pay you $5 of interest per year, leaving your account with $105 by year’s end. However, after the recent financial & economic meltdown, savings rates have dropped to a dismal .05% APY, meaning that for every $100 invested $.05 (yes, that’s cents) would be earned, leaving you with $100.05 by year’s end. Still, the lesson: regardless of how much your money earns, it earns something, and that something is the time value of money. In other words, earn “money” by having money.
IMPORTANT: Money today is worth more than the same amount in the future because of its Potential Earning Power (and Inflation).
If you were offered ‘$100 in the future’ or ‘$100 today’, you would prefer the money today. Why? Because at that specified moment in the future, the offer would be ‘$100’ or ‘$100 and all the money earned’ respectively. This assumes you were a reasonable person and invested the money to appreciate.
I understand that the following goes without saying, but sometimes you just don’t know, and savings accounts are not the only way to watch your money grow. Several investment vehicles exist and while riskless options are available, many individuals with thick skin and a hearty appetite for adventure stand to make a significant return on their investment. So we find ourselves at the ever-important Opportunity Cost.
Opportunity Cost can be defined as what one gives up as a result of an investment decision (the other option). Any decision that involves a choice between two or more options has an opportunity cost.
Let’s bring this all back to Commercial Real Estate and why TVM and Opportunity Costs matter. Some investors abhor risk, otherwise called ‘risk-averse’, and find a U.S. Treasury, Savings Account, or a heavy mattress to be the only conceivable form of investment. But risk is healthy, and some understand that ‘risk-tolerance’ has potential for a reasonable earning. So you’d invest in a bond, a fund, an apartment building or even a neighbor’s startup company. The opportunity cost of choosing any one of these scenarios is what you’re giving up by not choosing the other scenarios. Below is a limited and assumptive guide to alternative investment options and is used for illustrative purposes only. It encompasses both the ideas of Time Value of Money and Opportunity Cost together.
In this example, should you have been presented with the option of investing $1,000,000 in Commercial Real Estate or receiving $1,000,000 a year from now, you would have been $70,000 better off for taking the million and investing, versus taking the $1,000,000 one year from now.
These examples are based on historical norms and averages, and if you’ve noticed Bernie Madoff offering 20% interest, there can be significant downside to poor/high risk investments!
I hope this was helpful and painless. Please comment with your thoughts, especially if you find anything helpful or difficult to understand! We love discussions.