Finance Principles and Tools for Building a Pro forma

Finance principles are a category of mental models used when assembling a pro forma. These include the time value of money, which is effectively how the value of a dollar today is worth more than the value of a dollar tomorrow. The difference in that value is what’s called the discount rate, which accounts for both the risk and the time value of money.

There are different discount rates applied to different investment instruments, but in general, they all say the same thing. There are several explanations for why this is the case, but if you are going from $1 dollar today to a dollar tomorrow, the dollar today is worth more based on time, value, and investment return on the $1 dollar if its invested over this single day. The investment return for investing in an alternative during this 1 day is termed your opportunity cost of your capital. Based on first principles, what you call the discount rate is the rate you assign to future cash flows, to convert them to be the present value of those cash flows based on this time value of money, the associated risk or probability of actually earning those cash flows and your opportunity cost of capital. You may be valuing a series of cash flows over time or a single lump sum cash flow later and you want to understand and to assign the discount rate to that.

Well what helps you to understand what should be the discount rate?

If you’re buying a piece of raw land on the beaten path, you have to get government and local permits to even put in utilities. In this example, you might evaluate that the land today is worth X, but with the new building built on the land, the building tomorrow is worth Y. The discount rate, together with the time value of money, factors in the risk associated with achieving the proposed value.

Well, what are your alternatives? What else could you do to get that same discount / rate of return? Your calculated discount rate establishes the market cap, for a raw piece of land the rate of return could be 20%, but if it’s not happening for 10 years, what is the value of that deal today? We can use the discount rate to get to the present value, which allows us to compare this rate to other alternatives. For example, what would the rate of return be if we were just buying a bond on the public market? If the bond’s rate of return is 10% which would pay out in five years, where would you prefer to invest the capital? Looking at the two values, if the land has a 20% rate of return but the bond is worth more today and it is lower risk, you would ask yourself which of the two deals you prefer. You may prefer the 5%.

These principles are really important in setting your target return, which factors in the time value of money, the opportunity cost of that money – meaning the alternative returns that money can get – and then the risk associated with achieving it. These are the three components of setting your rate of return and embody 80% of finance principles for commercial real estate investing.

Read next… “Valuation Principles that Incorporate Financial Tools and Critical Thinking”