Following up on our “Investment Lending Metrics Explained” series, we will be breaking down three commonly used terms in the real estate investment industry. Let’s get to it!
While the discount rate can refer to either the interest rate charged to financial institutions for the loans they take from the Federal Reserve Bank or the rate used to discount future cash flows in discounted cash flow (DCF) analysis, our focus will be on the latter. DCF is a method used by real estate investors to help determine the value of an investment based on its future cash flows. The formula can be written as follows:
DCF = (Cash flow for the first year / (1+r)1)+(Cash flow for the second year / (1+r)2)+(Cash flow for N year / (1+r)N)+(Cash flow for final year / (1+r)
The “r” represents the discount rate, which is the rate used to discount the future cash flows from an investment to the present value to determine if an investment will be profitable. As the formula shows, discount rates are applied to future income streams. Many large brokerage companies conduct discount rate surveys for real estate investors.
Net Present Value is the value of all future cash flows over the entire life of an investment discounted to the present. It is used to calculate today’s value of a future stream of payments. The net present value analysis subtracts the discounted cash flows from your initial investment.
NPV = (Cash flow/1 + r) N – initial investment
IRR is the annual rate of growth an investment is expected to generate. IRR is calculated using the same concept as NPV, except it sets the NPV equal to zero. In other words, the IRR represents the discount rate that makes the NPV of future cash flows equal to zero.
0 = (Cash flow/1 + IRR) N – initial investment
Suppose, for example, you have $100,000 to invest in a property, and the rental is estimated to pull in $20,000 in cash flow each year for the 10 years you plan to hang on to the property. The IRR will be the interest earned over the full 10-year period, or 15.1%.
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