Wealth Opportunities in Commercial Real Estate: Management, Financing, and Marketing of Investment Properties

Compounding

It is important to understand the concept of compounding and its applicability to a real estate investment analysis. One dollar invested in a saving account earning 3 percent would increase to $1.03 by the end of the year. The same account at the end of year two would be worth approximately $1.0609. The crucial factor is that the growth in the account is from the $1.03 starting point, and not from the original dollar. You earn interest on the interest.

Similarly, in the real estate rental context, if year one base rent is $1,000 per month and the adjustment is 5 percent, then the year two base rent is $1,050 per month. At the beginning of year three, the base rent becomes $1,102.50 per month. To calculate the rent increase you multiply 5 percent times the immediately prior monthly rent of $1,050 and then add that amount to the base rent. The point is that by contract you usually do not go back to the original base rent of $1,000 and determine the increase by multiplying 5 percent times the original base rent. If you went back to the original base rent, the result would be a $50 increase per year, which when added to year two base rent would result in a base monthly rent of $1,100 rather than $1,102.50. You calculate the third-year rent amount based upon the immediately preceding year's rent, not on the original rent level. The effect is not dramatic in the above example since the rental amount and the percentage increase is relatively small, yet if the base rent is ...