Discounted cash flow analysis for real estate is widely used, yet often misunderstood. In this post we’re going to discuss discounted cash flow analysis for real estate and clear up some common misconceptions. As you follow along, you might also find this discounted cash flow analysis spreadsheet template helpful.
Discounted Cash Flow Real Estate Model
First, let’s dive into the basic real estate cash flow model in order to understand how a discounted cash flow analysis is constructed. Four basic questions must be answered in order to understand any real estate investment:
- How many dollars go into the investment?
- When do the dollars go into the investment?
- How many dollars come out of the investment?
- When do the dollars come out of the investment?
In real estate finance, the answers to these four basic questions are boiled down to a simple diagram:
The holding period is shown in years on the left hand side of the diagram. It is usually assumed that the timing of the cash flows occur at the End of the Year (EOY). In commercial real estate, the holding period is typically between 5-15 years for the purposes of a financial analysis.
The initial investment is normally shown in time period zero (0) and includes all acquisition costs required to purchase the asset, less any mortgage proceeds. In other words, this is your total out of pocket cash outlay required to acquire a property.
Annual Cash Flows
The annual cash flows before tax for a real estate investment property are typically broken out line by line on a real estate proforma. The cash flow before tax is the net result of gross income minus expenses and debt service. If cash flow is negative it means dollars are going into the investment, and if cash flow is positive it means dollars are coming out of the investment.
Sale proceeds represent the net cash flow received from the disposition of an investment property. This cash flow item shows up in the last period of the holding period of the real estate cash flow model.
What is Discounted Cash Flow Analysis?
With the components of the real estate cash flow model out of the way, let’s dive into discounted cash flow, or DCF for short. Discounted cash flow analysis is a technique used in finance and real estate to discount future cash flows back to the present. The procedure is used for real estate valuation and consists of three steps:
- Forecast the expected future cash flows
- Establish the required total return
- Discount the cash flows back to the present at the required rate of return
Forecasting the expected future cash flows involves creating a cash flow projection, otherwise known as a real estate proforma. This puts into place all of the elements discussed above and allows us to answer the 4 basic questions of the real estate cash flow model (How many dollars go into the investment? When do they go in? How many dollars come out of the investment? When do they come out?)
Establishing the required total return (also known as a discount rate) for a project will be specific to each investor. For an individual investor, this is typically their desired rate of return. In the case of a corporate investor, the required return is typically the weighted average cost of capital (WACC). Ascertaining the discount rate also includes accounting for the perceived riskiness of the project compared to alternative investment opportunities.
Once the cash flows have been forecasted and the discount rate has been established, a discounted cash flow analysis for a real estate project can be used to determine the internal rate of return and net present value. Below we will discuss these measures of investment performance, including the mathematics of discounted cash flow analysis. To get a more intuitive understanding of internal rate of return and net present value, check out the Intuition Behind IRR and NPV.
Net Present Value (NPV)
The net present value (NPV) is an investment measure that tells an investor whether the investment is achieving a target yield at a given initial investment. NPV also quantifies the adjustment to the initial investment needed to achieve the target yield assuming everything else remains the same. Formally, the net present value is simply the summation of cash flows (C) for each period (n) in the holding period (N), discounted at the investor’s required rate of return (r):
Internal Rate of Return (IRR)
Internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested. IRR is also another term people use for interest. Ultimately, IRR gives an investor the means to compare alternative investments based on their yield. Mathematically, the IRR can be found by setting the above NPV equation equal to zero (0) and solving for the rate of return (r).
How to use IRR and NPV
Essentially, the IRR tells you the total return on the project, given the projected cash flows. The NPV, on the other hand, tells you how much more or less your initial investment needs to be in order to achieve your desired rate of return. How can you use these measures of investment performance in the real world?
Let’s say you have $1 million to invest and you’ve identified 5 potential commercial properties where you can invest your capital. Completing a discounted cash flow analysis for each of these real estate projects will enable you to make a decision regarding which asset to acquire. Comparing the internal rates of return for each project will tell you which asset will provide the highest return. Alternatively, given your desired rate of return, the net present value will tell you which asset provides the highest value stream of cash flows.
Ignore at Your Peril
It is also important to note that many analysts ignore discounted cash flow indicators and instead use simple measures of investment performance, such as cash on cash return or the gross rent multiplier. While these simpler ratios are useful when evaluating an investment, they also ignore the multi-period changes in cash flows over a holding period and can lead to dramatically different results.
The discounted cash flow analysis takes into account all cash flows in the holding period, and as such is a crucial tool in the commercial real estate practitioner’s toolbelt that should not be ignored.
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