Question about the time value of money (Frank Gallinelli)

[David Sienema]

Hello all,

This is my first post on BP and I am excited to dive in. Thanks in advance to anyone who reads this or replies.

I've been reading Frank Gallinelli's book What Every Real Estate Investor Needs to Know About Cash Flow, and I have a slightly technical question that I thought I'd put out to this community.

In this book, he talks quite a lot about money having a time element to its value, therefore, he reasons, in future projections, it becomes useful to discount money you will receive in the future to determine its 'Present Value' (PV). Future money is discounted by the rate of return you could expect to earn on that money had you been free to invest it elsewhere TODAY. My confusion is this: if you only have a certain amount of money to invest, why would it be assumed that you could invest that money or its gains elsewhere in the meantime, therefore netting another return, therefore justifying the discount of dollars received in the future? It's not like you can invest the same money in multiple places, and it's additionally very rare that you can get an immediate payout on an investment, so why would we discount future money by the rate of return, when there seems to be no reasonable scenario where we could actually have that money today, or any sooner at all?

I'm sure I've made my point about as clear as mud. I'll give a quick example from the book. If you were to receive $21,000 of profit in year 5 of an investment, the PV of that money, when it is discounted at 11%, is $12,462. But unless there is some magical way to actually have that $21k in hand at the beginning of year 1, rather than in year 5, why would assume that we might have been able to make a return on that money in the intervening years, when in order to make a return on it, it would have to be OURS, but in order to be ours, we (as investors) have to wait for our investment to earn that return?

Many thanks everyone! Glad to be part of this community, I will be participating more beginning TODAY!

David.

[Frank Gallinelli]

Hi @David Sienema -

Greetings here from the perpetrator of the book that you’ve been reading. Without getting too deep into the math weeds, permit to elaborate.

As you know, when you consider purchasing an investment property, you are really purchasing a future income stream, with each bit of income occurring at a different point in the future and in a different amount. Your first, and most logical concern will be, how much is that future stream of income worth (in other words, how much should I pay for it) if I expect to make an x% profit for my trouble?

It’s not really worth the total face amount of those future income events (let’s call them by their proper name — cash flows). It’s worth less than that because if you had received all of that money at once, today, then you could have gone out and invested it all and made more money with it. But you didn’t get it all today, so that’s the reason for discounting the value of each of the expected future cash flows — and indeed that’s why this process has always been called “discounted cash flow analysis.” A return deferred is a return less valuable.

BTW, you’re on to something when you point out that you couldn’t necessarily reinvest a small cash flow at the same rate as what the overall property earns. That’s why there is a reinvestment rate variable for those who use Modified Internal Rate of Return as part of their investment analysis. But that’s a chapter for another day ;)

Best regards,

Frank G