The 9 Must-Know Finance Concepts For Real Estate Professionals

When it comes to real estate finance discussions, often only a few core ideas make it into the regular vocabulary and routines of professionals.

There are many finance concepts that one could explore — Investopedia alone has a log of over 200 real estate terms. But when you’re a real estate professional trying to make educated decisions in time sensitive situations, you have to be prepared to let go of noisy variables that are: tough to grasp and when grasped, tough to apply and when applied, tough to interpret.

Of the many finance concepts that could creep into the real estate umbrella, the nine below will have the biggest impact on analyzing and understanding the quality of an opportunity. Many of these concepts are directly related and are used together in practice. They will also be particularly valuable as you engage in real estate financial modeling.

The 9 Must-Know Finance Concepts For Real Estate Professionals

  1. Time Value of Money: The idea that a dollar (or other unit of currency) received today is worth more than a dollar received in the future due to opportunity cost, inflation expectations, and the certainty that it will, in fact, be received.
  2. Compounding: The process of earning interest on an asset or other investment instrument where the interest can itself earn interest. Interest earned in one period earns additional interest during each subsequent time period.
  3. Discounting: A procedure used to convert future cash flows (including income and one-time events like sales) into a present value or future value at a time period that is earlier than when the cash flows occur by using a specified percentage, or “rate.”
  4. Present Value: An asset’s worth after applying discounting to all future cash flows to today (or “time period 0”, the start of analysis) at a specified rate.
  5. Future Value: An asset’s worth at a specified date in the future after applying a constant rate of growth to the asset and interim cash flows, basing the number of periods applied to the rate of growth on when the interim cash flows occur.
  6. Net Present Value: The difference between the present value of all expected future cash flows and the present value of all capital outlays.
  7. Inflation: A general increase in prices, usually resulting in declining purchasing power of money.
  8. Positive/Negative Leverage: (1) When the cost of borrowed funds is higher (positive) or lower (negative) than equity investment returns, in turn pushing returns higher or lower, respectively, than if the equity investor was not using leverage. (2) When analyzing cash flows, positive or negative leverage occurs when the overall capitalization rate (net operating income divided by value) is greater or less than, respectively, than the mortgage capitalization rate, aka “loan constant” (loan payment divided by current loan balance).
  9. Velocity of Money: The speed at which invested capital is returned to the investor.

Applying these principles can actually be fun (!) because they can be eye-opening — even paradigm shifting. They often expose stakeholders to new perspectives, and can be used in pitches and meetings with investors to let them know that you know a deal inside and out.

For example, say a buy-and-hold investor is focused on cash-on-cash returns and internal rate of return (IRR) when analyzing potential acquisitions. If he doesn’t understand the “discounting” concept that is core to the IRR, he won’t realize that negative cash flows in future years are being discounted at the same rate as positive cash flows. The result is that future liabilities (in this case, the negative cash flow) may have less of an impact on net present value than they should by the time they are discounted to time period zero.

For those who want to get into the weeds a bit: a better way to handle analyses of properties with frequent and/or significant negative cash flows is to use the modified internal rate of return (MIRR) which includes a “safe rate” (AKA finance rate) assumption which is applied to negative cash flows when discounting. The safe rate is usually lower than the reinvestment rate, which results in a higher liability at time period 0, better preparing the investor to set aside funds in a safe (lower risk + lower rate of return) investment vehicle early on to ensure adequate funds are available to cover the negative cash flows.

In future articles we’ll explore use cases showing standard and unique applications of these concepts, including how pros use them to make better decisions or advise others.

Tom Blake is a co-founder of Dropmodel. He is an active real estate investor and has previously held roles as an asset manager and commercial investment sales broker. He holds an active broker’s license in California, Texas, and Nevada, and the Certified Commercial Investment Member (CCIM) designation.

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