An analysis using discounted cash flow (DCF) is a very commonly used measure in the valuation of real estate investments. Admittedly, determining the discount rate – a crucial part of DCF analysis – involves a number of variables that can be difficult to predict accurately. Despite the difficulties, the DCF remains one of the best tools for valuing real estate investments, such as real estate investment trusts (REITs).
Key points to remember
- Discounted cash flow (DCF), a valuation method used to estimate the value of an investment based on its future cash flows, is often used to value real estate investments.
- The initial cost, annual cost, estimated income and holding period of a property are some of the variables used in a DCF analysis.
- Although the real estate discount rate can be difficult to determine, the DCF remains one of the best tools for evaluating real estate investments.
What is a discounted cash flow?
Discounted cash flow analysis is a valuation method that seeks to determine the profitability, or even mere viability, of an investment by examining its projected future earnings or projected cash flows from the investment and then discounting this cash flow to arrive at an estimated present value. investment value. This estimated present value is commonly referred to as net present value or NPV.
In other words, DCF analysis attempts to determine the value of a business or asset today, based on projections of how much money it will generate in the future. A discount rate is used to calculate the NPV of expected future cash flows. For the valuation of real estate investments, the discount rate is usually the desired or expected annual rate of return on real estate. Depending on how far into the future you go, the DCF formula is:
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The ultimate goal of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money.
Calculation of discounted cash flows for real estate
For real estate investments, the following factors should be included in the calculation:
- Initial cost—Either the purchase price or the down payment made on the property.
- Discount rate—The required rate of return.
- Holding period – For real estate investments, the holding period is generally calculated for a period between five and 15 years, although it varies between investors and specific investments.
- Additional Year-to-Year Costs—These include scheduled maintenance and repair costs; property taxes; and any other costs in addition to finance charges.
- Projected Cash Flow – A year-by-year projection of any rental income received from ownership of the property.
- Profit from Sale – The projected amount of profit the owner expects to make when selling the property at the end of the projected holding period.
A number of variables must be estimated in the calculation of the DCF; these can be difficult to pin down precisely and include things like repair and maintenance costs, expected rent increases and increases in property value. These items are usually estimated using a survey of similar properties in the area. Although it can be difficult to determine precise numbers to project future costs and cash flows, once these projections and the discount rate are determined, the calculation of net present value is quite simple and computerized calculations are freely available.
Example of the use of DCF in real estate investments
An investor could set his DCF discount rate equal to the return he expects from an alternative investment with similar risk. For example, let’s say you could invest $500,000 in a new home that you think you could sell in a decade for $750,000. Alternatively, you could invest his $500,000 in a real estate investment trust (REIT) which is expected to earn 10% per year for the next 10 years.
To simplify matters, suppose that you do not include the opportunity costs of rents or tax effects between the two investments; we’ll stick to one cash flow—the price of the house in 10 years. So, all you need for the DCF analysis is the discount rate (10%) and the future cash flow ($750,000) from the future sale of the house.
In this example, the DCF analysis shows that the house’s future cash flows are only worth $289,157.47 today. So you shouldn’t invest in it; the REIT, which will fetch nearly $800,000 over the next decade, offers better value.
