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Part 2: Math and Metrics: Time= Money

One of the Big Ideas in real estate is the importance of a long term perspective: anybody in the real estate business who is trying to maximize this year’s profit as their primary goal is trying to answer the wrong question. It is too easy to increase the profit of an operation (this year) by reducing maintenance on a critical system or selling an otherwise good property for less than it is worth. The idea is simple but what is the alternative? 

Bad decisions look good to people who focus on the current profit but they look bad when evaluated in terms of the capital value of an asset.  Similarly, because an asset produces a flow of income for many years in the future, it is worth more than what it will produce during the next 12 months.  For this reason, any analysis of capital value usually starts with some kind of a net present value calculation or discounted cash flow analysis which compares money received now with money received in the future.

To some high school students, this kind of calculation may be taught as an obscure trick in a math class with little relevance. To practitioners, this calculation is used so often that the function is built in to most spreadsheet programs [1]  [2] and many calculators. Some experienced practitioners can do the math in their head.

Students who think that they can survive by memorizing the formula, without understanding its meaning, often find themselves confused by trivia.  For this reason and to help when negotiations become serious, our classes explore this value calculation from many perspectives.

The simple formula taught in a high school math class is too simple to be accurate but it is a very good starting point and reveal a vitally important life lesson.  To account for special features of a situation, the standard formula can be refined and disguised using terms like “internal rate of return”“option value”, or  “Monte Carlo simulations” and others.  These variations are interesting because the calculations invoke different kinds of perspectives, behaviour and situations.  Research is also showing that the simple ideas are not quite right.  These changes open new opportunities to people who understand.

Competitive pressure tempts people to tweak a formula to make a report look better.  So, despite what I said in another post, financial analysis is not all that easy.  It is important to learn enough to prevent being misled by others or by oneself.

PA

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