Discounted Cash Flow For Real Estate

What is discounted cash flow and why is it important

Real estate investors buy properties that they hope in the future will earn them a considerable return.

To truly understand what that value is, investors can use discounted cash flow to estimate the value of that home in the future, with future cash flows in mind, during the time period they own it.

What is discounted cash flow analysis?

Discounted cash flow is a metric used by investors to determine the future value of an investment based on its future cash flows.

For example, if an investor buys a house today, in 10 years, they hope it will sell for more than what it is worth today. But that’s not the only income — or expense — generated by the property. If the home is utilized as a rental property, cash comes in. If the investor plans a renovation, money goes out. All of this is cash flow. It helps determine the future value of a home for an investor. The discounted cash flow helps investors figure out what that future value of the cash flow is.

Discounted cash flow helps investors evaluate how much money goes into the investment, the timing of when that money is spent, how much money the investment generates, and when the investor can access the funds from the investment. For more help managing your cash flow as a commercial investor, check out this post.

The formula will take into account Initial cost, annual cost, estimated income, and any necessary holding period.

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How do you calculate discounted cash flow?

Investors can use a basic formula to calculate the discounted cash flow model. Before getting started on your DCF analysis, have the initial cost of the property, any interest rates, the year-by-year expenses and profits, and any holding periods laid out. The holding period is how long you plan to own the investment, which for most, is typically between five to 15 years.

Then, you can use the following formula:

DCF = CF1 / (1 + r) 1 + CF2 / (1 + r) 2 + … + CFN / (1 + r)N

DCF = Discounted Cashflow

CF = Cash Flow

r = discounted rate

Each subsection of the formula allows investors to evaluate their cashflow by a particular year to see how much money is coming in. The subsection repeats for however many years you estimate you’ll own the investment property.

An investor can determine a property’s cash flow by calculating the following:

  • Initial investment: Cost of purchasing the property
  • Income: rental income, payments from vacation rentals
  • Expenses: mortgage payments, utilities, upkeep, cost of debt
  • Estimated sales proceed the year the property is sold

For new investors, the formula can seem like a foreign language, but users can use Excel to determine the discounted cash flow. Excel classifies this as =NPV.

When do you use discounted cash flow?

Real estate investors use discounted cash flow when trying to determine a low-risk investment’s value in the future when they’d want to cash out. In the investment banking world, companies can use the discounted cash flow formula to know if the value of a business is a good long-term investment, as well. A DCF analysis also helps investors know if the investment is a fair value or the true value of a company.

It’s important to note that investors will use estimates in a DCF valuation, because they’re predicting the future, so the result is also an estimate. If you have bad estimates, the result will be flawed. The discounted cash flow method is still one of the best tools for investors to determine an investment’s total value.

How is discounted cash flow different?

Investors can also use the Internal Rate of Return formula and Net Present Value or other metrics such as cash flow, cash on return, or cap rates to determine a property’s potential value.

Discounted cash flow differs from the other valuation methods by allowing investors to determine the value of the projected future cash flow in today’s time. Other metrics, such as Net Present Value, can evaluate the return on the total investment. The IRR formula uses the discounted cash flow to determine a real estate investment’s up or downside.

While not perfect, using a DCF model helps real estate investors evaluate the expected cash flows coming in and out of their property, at a risk-free rate, over the forecasted holding period and determine the future value of their cash flow projections. This information helps real estate investors make better investment decisions.

 

Discounted Cash Flow Analysis for Real Estate

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:

  1. How many dollars go into the investment?
  2. When do the dollars go into the investment?
  3. How many dollars come out of the investment?
  4. 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:

discounted_cash_flow_model

Holding Period

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.

Initial Investment

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

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:

  1. Forecast the expected future cash flows
  2. Establish the required total return
  3. 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):

npv_formula

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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