The business plan for all commercial real estate (CRE) assets is essentially the same. An investor purchases a property and leases the space in it to a series of tenants. The resulting income is used to pay for the property’s operating expenses (including debt service) and anything left over is distributed to owners/investors at the end of each year.
Given this business plan, it follows that the value of a commercial real estate asset is driven by the amount of cash flow that it produces. One of the primary techniques that commercial real estate investors use to value a series of cash flows is called Discounted Cash Flow Analysis or simply “DCF” and it is the subject of this article.
Understanding the Time Value of Money
The main concept behind DCF analysis is known as the “time value of money” which states that a dollar today is worth more than a dollar in the future due to its ability to be reinvested and earn interest.
Using the time value of money concept, a series of future cash flows can be valued by “discounting” them back to the present time. The first step in this process is determining exactly what the cash flows are.
Estimating Cash Flows
There are two components of commercial real estate cash flows: (1) Recurring annual cash flow from property operations; and (2) The sale of the property at the end of the investment holding period. Each one is estimated slightly differently (NOTE: For the purposes of this article, it is assumed that no debt is used in the purchase of the property).
Forecasting recurring cash flows can be tricky. It requires estimating annual rental income and all property operating expenses for the duration of the investment’s holding period. This estimate requires a series of assumptions about income and expense growth rates as well as a series of leasing assumptions about market and renewal rates at the time leases expire. Calculating recurring cash flows is part art and part science and it is understood that they are estimates only, but they should be supported by data to the extent possible.
At the end of the holding period, the typical business plan requires a property sale, which results in a large cash inflow. Estimating the sale price with a high degree of accuracy is also tricky because it occurs many years in the future. However, the best practice is to apply a capitalization rate (cap rate) to the cash flow in the final year.
Once these components have been estimated, the next step is to choose a discount rate.
Choosing a Discount Rate
The discount rate is one of the most important choices when performing discounted cash flow analysis.
Remember, property cash flow forecasts are just estimates. And, the further into the future they occur, the less accurate they are. Thus, the choice of a discount rate should reflect the expected variability in cash flow estimates over time and the identified risk factors in the transaction.
An easy way to think about the discount rate is as the expected Internal Rate of Return (IRR) for the investment holding period. There is no “right” choice, but there are options supported by data and those that aren’t. In general, commercial real estate discount rates are between 5% and 13% for most investments.
Performing Discounted Cash Flow Analysis
With the inputs known, DCF analysis can be completed. Although it is commonly done in a spreadsheet program like MS Excel, it can also be calculated manually using the following formula:
Translating the formula into plain language, each annual cash flow / net operating income (NOI) is divided by one plus the discount rate, raised to the period number. To illustrate how this works, an example is helpful.
Assume that an investor is considering the purchase of a commercial property. It has an estimated market value of $1,000,000, but they are trying to independently determine the value of the property through discounted cash flow analysis. They have created a proforma with the property’s projected cash flows as follows:
The cash flow in the final year represents both the cash flow from operations as well as the proceeds from the sale. Using the DCF formula and a discount rate of 9%, these cash flows can be discounted to determine the present value as follows:
Based on these cash flow projections and the chosen discount rate, the DCF model indicates an estimated valuation of $928,225.
What to Do With the Result
When the present value has been determined, it is only logical to think about what to do with it. At its core, it provides a reference point to the property’s purchase price.
In the example above, the property has an asking price of $1,000,000, but the DCF valuation method indicates a value of $928,225, which is clearly less than the asking price. So, it would be logical to approach the seller with an offer based on the results of the investment analysis and use it as a starting point for negotiation.
However, it is important to note that both the choice of a discount rate and the property’s expected cash flows are estimates only. Thus, it is possible for two parties to look at the same property and come up with a totally different estimate of value based on their perception of risk in the transaction.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
When evaluating potential properties for purchase, we always perform discounted cash flow analysis to ensure we don’t overpay for the asset.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.