Using Discounted Cash Flow (DCF) Analysis to Evaluate Real Estate
At the most fundamental level, a commercial real estate investment involves investing a sum of money today to purchase a stream of income in the future. The concept itself is simple, but the hard part can be trying to determine how much to pay for that stream of income. To do this, investors perform financial modeling to help them estimate the value of the property. One of the most widely used, and often misunderstood, cash flow models used to value a stream of income is known as Discounted Cash Flow analysis. It can be used to value almost any asset class, but is particularly relevant in commercial real estate (CRE) transactions.
In this article we will discuss the discounted cash flow concept, how to calculate it for real estate, and which variables are needed to do so. By the end of the article, investors will have the information necessary to understand how a discounted cash flow analysis can be used in the context of commercial real estate investing.
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What is Discounted Cash Flow Analysis?
Discounted cash flow (DCF) analysis is a valuation method used to determine the present value of an investment by projecting its future cash flows and discounting them back to the present using a discount rate. The present value represents the investment’s value based on the future cash flows it is expected to generate and an appropriate discount rate, which is based on market conditions, interest rates, and the riskiness of the investment.
The theory behind discounted cash flow analysis is known as the “time value of money,” which is the idea that a dollar today is worth more than a dollar in the future due to its ability to earn interest over time. So, it follows that the value of an asset today is simply the sum of all future cash flows, discounted for the risk associated with earning them.
How to Calculate Discounted Cash Flow for Real Estate
Mathematically, the formula for calculating an asset’s present value is:
If you are intimidated by this equation, don’t be. The actual calculation is typically performed by using the “NPV” function in an Excel spreadsheet with the following syntax:
NPV = (Discount Rate, Cash Flow 1, Cash Flow 2, Cash Flow 3, Cash Flow 4, Cash Flow 5,…)
Variables Needed to Calculate DCF
No matter the method used, three variables are needed to calculate net present value in a DCF valuation:
- Cash flow per period
- Discount rate
- Number of periods
Let’s break them down individually.
1. Cash Flow Per Period
A property’s cash flows are forecasted for a specific holding period, and they can be broken down into two parts – recurring cash flows and terminal cash flow.
Recurring Cash Flows
In commercial real estate, recurring cash flows refer to the regular, periodic income that a property generates. This income can come from a variety of sources, such as lease payments from commercial tenants, and any other fees or charges associated with the property.
Forecasting recurring cash flows is an important aspect of owning and operating commercial real estate. It is important to accurately project cash flows in order to make informed investment decisions.
In order to forecast recurring cash flows, investors will usually create a document known as a proforma. The purpose of this document is to project the net operating income (NOI) of the property on a periodic, usually monthly or annual, basis. A proforma incorporates the income and expenses associated with a given property. Income is derived from tenant lease payments or unit sales, and expenses are estimated by reviewing a combination of historic property performance and current market conditions.
The difference between the income and expenses for each year in the holding period is the cash flow number used in the DCF model. Because recurring cash flows can go on for many years, the equation can become quite lengthy, many investors use an NPV spreadsheet function for simplicity.
To summarize, there are several factors that can impact the recurring cash flows of a commercial property, and in turn, the property’s market value. These include the type of property, the location, the condition of the property, and the demand for the property in the local market. Understanding these factors can help a commercial real estate investor build more accurate proforma statements and make better investment decisions.
Terminal Value
Even the best commercial real estate investors understand that it is difficult to project cash flows for many years into the future due to uncertainty around market conditions, changes in tenant mix, and changes to tax or insurance costs. For this reason, a recurring cash flow forecast will typically look out ten years or less. The investor may plan to hold the property beyond this period, and they need a way to account for the cash flows that will be received further into the future.
This is where the terminal value of future cash flows comes into play. In real estate finance there is a concept known as the “terminal value” of an asset. It implies that an asset has value well into the future, up to the time the property reaches the end of its useful life. The income earned between the end of the period captured in the recurring cash flow forecast and the end of the property’s useful life is known as the “terminal cash flow”.
Terminal cash flow is calculated by taking the cash flow for the final year in the recurring cash flow forecast and applying a growth rate to it. This growth rate is meant to capture the expected, average annual rate of growth in NOI over the entire holding period. Then, a discount rate is also applied to calculate the terminal cash flow value.
The equation used to calculate the terminal value of the cash flow is as follows:
Terminal Value = [FCF x (1 + g)] / (d – g)
- FCF is the free cash flow, or NOI, in the last recurring cash flow forecast period.
- g is the assumed growth rate.
- d is the discount rate. Many investors will use the weighted average cost of capital (WACC) as the discount rate. We’ll talk more about this in the next section.
2. Discount Rate in Commercial Real Estate
Under the discounted cash flow method, the discount rate is the interest rate used to determine the present value of an asset. In practice, choosing a discount rate in a real estate DCF analysis is a mixture of art and science.
Qualitative Discount Rate Considerations
The discount rate used to analyze a real estate investment is based on the level of perceived risk in the real estate transaction. An investor will typically require a higher rate of return on a riskier investment, and therefore, will use a higher discount rate in the DFC analysis. An investment with low perceived risk will call for a lower discount rate.
Gauging the level of risk in a real estate investment involves the analysis of several variables that may be difficult to quantify, including: property type, tenant mix, location, and the general economic conditions at the time of analysis.
Quantitative Approach to Discount Rates
Many analysts will base the discount rate on the risk-free rate plus a spread to account for the risk involved in the real estate investment. The risk-free rate is often the rate quoted on a government security, like a Treasury Note. The 10-year Treasury is commonly used as a proxy for the risk-free rate in commercial real estate investing.
Another approach to calculating a discount rate is known as the weighted average cost of capital (WACC) approach. This involves calculating the average cost the investor incurs for using debt and/or equity capital to fund a real estate investment. The WACC is calculated by multiplying the cost (in percentage terms) of each capital source – usually debt and equity – by the respective weighting of each.
The formula for WACC is Debt Weighting x Cost of Debt + Equity Weighting x Cost of Equity.
For example, if an initial investment is funded using a mix of 70% debt at an interest rate of 5% and 30% equity at a cost of equity of 8%, then the WACC would be calculated as follows.
70% debt weighting x 5% cost of debt capital + 30% equity weighting x 8% cost of equity capital = 5.9%
The WACC in this example is 5.9%, and this would be used as the discount rate in the DCF model. Note that this example ignores the impact of a potential tax shield from taking on debt financing. Every investor has a different tax situation and should speak to a tax professional prior to making an investment.
Generally speaking, there are some commonly accepted ranges within which the discount rate for real estate should fall; for most commercial real estate transactions, the discount rate should fall between 8% and 12%. There is no definitive “right” or “wrong” discount rate, but the ultimate choice should be fully supported by market knowledge and data.
3. Number of Periods
A discounted cash flow analysis is usually based on annual cash flows. For an investment property, a “holding period” must be estimated, and it is equivalent to the number of years that an investor plans to own the property. Because discounted cash flow analysis has a time component, the number of years in the holding period will have a material impact on the final result.
For example, if an investor plans to purchase a value-add property, rehab it, lease it up, and then sell it a couple years later, the majority of the investment’s value may be based on the exit value, or expected sale price. On the other hand, an investment that will be held for many years will derive much of its value from recurring cash flows.
Discounted Cash Flow Real Estate Evaluation Examples
To illustrate how discounted cash flow analysis works for evaluating real estate investments, let’s go through two examples, a simple one and a slightly more complex one.
A Simple DCF Cash Flow Valuation Example
For the simple example, assume that we are considering a purchase of a property that produces $10,000 in cash flow per year. Let’s also assume that our discount rate is 8.00% and that our holding period is 3 years. Using these three variables, the net present value for this series of cash flows can be calculated as follows:
[10,000/(1+8%)]^1 + [10,000/(1+8%)]^2 + [10,000/(1+8%)]^3 = $25,770
The net present value of these cash flows is $25,770, and it represents the value of this stream of income to an investor with an annualized required rate of return of 8.00%.
A More Complex DCF Cash Flow Valuation Example
Assume that the annual cash flows and the discount rate are the same at $10,000 per year and 8.00% respectively. But, this time, let’s assume the cash flow in year 4 will be used to calculate a terminal value with an assumed growth rate of 3% and a discount rate of 8%. The cash flows are illustrated in the table below:
[10,000/(1+8%)]^1 + [10,000/(1+8%)]^2 + [10,000/(1+8%)]^3 + [10,000 x (1 + 3%)] / (8% – 3%) = $231,771
In this example the majority of the value from this investment comes after year three, which is captured by the terminal value.
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If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.