If you are going to be doing syndication, like I do, or if you are investing in a syndication, you will need to be able to evaluate the Internal Rate of Return (IRR). We use this among all the other metrics we generate as one piece of the puzzle that helps us come to a purchasing decision. The IRR has some complexity and as such is ignored by a lot of investors. Understanding it won’t make you a genius but it will definitely help you in your investments. The IRR is complicated so we need to break it down, starting with the time value of money.
The Time Value of Money
You might want to invest $100,000 in a new property. Is it a good deal? We calculate a cap rate (click to see previous post) among other things. These are great to tell us what our day-one statistics will be. They also help to give you an applies-to-apples comparison between properties. But what about the income in year 2, or year 5? Is the income in year 5 as good as the income in year 2? We vaguely know that we would rather have the money now than later, but there must be some measurable way to tell how much better that money is today than at some point in the future. My parents bought a house for our family in 1987 for $47,000. Seems super cheap doesn’t it? Yes, until you realize that money was ‘worth’ more back then. Our parents had less money, but everything cost less in those days. $47,000 in those days had the purchasing power that $106,000 does today. But now, their house is worth $220,000, so yea, Real Estate!
A paltry $10,000 in 1950 could have bought your parents a house. Instead, if they put it in a mattress for a rainy day it now can purchase 1/20th of a house. My point is, the value of money changes over time. It almost always decreases. The take home point here is that you need to do something with your money rather than bury it in the garden (except in dire economic situations, but if you are predicting that then you have a lot more to worry about).
Back to your $100,000
If you want to take that 100k and hold on to it, it will decrease in purchasing power at the rate of inflation, which has averaged 3.7% since 1950. Next year, your 100k only purchases what 96k would have purchased today. Which means, you better be doing something with your money rather than sitting on it (as long as you believe the economy will continue as it has).
When you consider purchasing that 100k property you will want to think about how much money it will make for you each year you own it. Let’s say the cap rate is an amazing 10%. That says that each year, your property will return to you 10k. Very nice, but each successive year, that 10k purchases less than it did today. At the end of year 5, it is only worth what 8.6k was worth today.
Hooray, Another Medical Example
We know from some (shaky) studies that each cigarette takes off 1 to 10 minutes of your life. So, it is great to quit now. But why not just quit later? Get those minutes back at the end of the life rather than suffer through quitting right now.
Another way to look at it is an investment in your health, by not smoking one cigarette, returns 10 minutes of your life, at the end of your life.
For instance, if you are going to smoke 20 cigarettes per day for 40 years then you will smoke 292,000, which is somewhere between 6 months and 5 years off your life. Your average life expectancy in America is 71 years. I can see the argument that a person might have: I don’t really care about the living I’ll be doing from age 66 to 71, I’ll gladly give them up to have that sweet, sweet smoke filling my lungs every 48 waking minutes.
OK, I really can’t see that argument. Cigarettes cause emphysema, coronary artery disease leading to heart attacks, and cancer. It takes few years to do its damage, though, so a cigarette not smoked now will have a greater impact on your life than one not smoked later. For example, granny smokes a cigarette at age 71 and doesn’t have that many years left to acquire cancer. If she is destined to have a heart attack next week, that one cigarette likely doesn’t take any time off her life. Many other things (not the least of which, old age, will far outweigh it). The damage done at age 14 from a single cigarette has many years to develop into cancer. Not to mention, that the 14-year-old has many more potential years of smoking ahead of him.
But that 14-year-old will see a much larger life impact of that single cigarette. If little Bobby wants to smoke you probably put a great deal of effort into teaching him not to. Granny?
“Oh, she will do what she wants to. Let her be happy.”
(With the short time she has left) is the unspoken suffix. In fact, the abrupt cessation of nicotine might harm her.
Little Bobby is only 14 years old, with a bright shiny life ahead of him. He falls in with a bad crowd, gets hooked on the cancer sticks, and you are his doctor and you tell him to quit. You give him all kinds of terrible statistics, like smoking kills 480 thousand people per year in America. You show him awful pictures of diseased lungs or people missing jawbones, but he sees right past it. He likes the feeling of being in a club and the feeling a cigarette gives him. He has a bright shiny life ahead of him and there are so many years that it doesn’t matter to him if he makes it to 71 or not.
As his doctor, you are ready to write him off, but then you remember this goofy real estate blog you read and you try a different strategy. You tell him about the time-value of cigarettes.
Actually, You Don’t, because it is Confusing as Heck
But for the purposes of this blog we will get into it. We can all agree that quitting smoking sooner rather than later is good. It adds 10 minutes per cigarette for your life, if the studies can be believed. Not only are you smoking less total cigarettes, but the earlier you quit smoking means more impact on your health as these early cigarettes are the ones that start the chain of events that take many years but can lead to devastating cancer. Each year goes by that Bobby doesn’t quit means less of a health impact by quitting. In fact, I’ll estimate that the impact is 3% less each year. There is also an element of uncertainty in his development of tobacco-related disease, meaning that he might develop cancer at age 16, but the cumulative risk goes up every year of smoking. I’m going to estimate a 3% risk of cancer year-over-year due to his tobacco use. Add that to my estimated 3% decrease in efficacy of quitting each year, we have a 6% decreased health impact every year by quitting. Keep track of this number, it’s an estimation, and in investing it is called a Discount Rate.
If Bobby smokes 20 cigarettes per day starting at age 14, but quits a year later, he will save 8.1 years of his life (he adds 8.1 years to his lifespan). That is approximately 20 cigarettes per day over a year times 10 minutes per cigarette. But if he quits at age 25, he will only save 3.2 years. That health investment by quitting smoking has a lower impact when done at a later age.
You tell this to Bobby and he shrugs and goes back to smoking. Billions of dollars have been thrown at youth tobacco use and yet those kids just don’t understand.
Understand it now?
I don’t expect you to honestly. Remember back from the last post, you would rather have money today than later, but not really sure why. Remember that inflation is always occurring. The money held in your hand for a year is worth 3.7% less. If your ‘investment strategy’ is to put your $100 bill in a box for a year, then take it out and spend it. It ‘cost’ you $100 to invest, you got that $100 back a year later, but it can only purchase what about $96.30 did today. That’s the time value of money. It almost always loses value over time. That $96.30 is what your investment is worth to you today. It could also be called the Net Present Value of the ‘investment’. The NPV comes in part 4.
I have a creeping feeling that I’ve been more confusing than helpful here. The important thing to remember is, like quitting tobacco at a later date yields less and less results each year, investment returns also are worth less and less each year. Future dollars are always worth less than they are today. That is the time value of money. Money earned today is worth more to you than money earned next year. This is why we cannot simply apply a cap rate to our equations for every future year of owning a property. We need to consider a discount for money for which we have to wait to receive until some point in the future, because it is worth less to us at that time. But how much less? Next time, we will apply this information to Discount Rates.