The Discounted Cash Flow (DCF) model is an analytical tool that is used widely in property investment analysis, and particularly for the estimation of the Present Value (PV) or Net Present Value (NPV) of the anticipated cash flows of a property over the planned holding period of the investment.
The model consists of a series of periodic cash flows, representing revenues and expenses of the property in each period, which are discounted to the present time (time 0) using a discount rate.
The Present Value estimates take into account all anticipated cash flows associated with the ownership of the particular property, except the initial cash outlay or investment cost at time 0, which represents the acquisition time of the property. In the Net Present Value model, however, the initial cash outlay in time zero is taken into account.
The two important things that determine the present value of a property investment in the discounted cash flow model are the series of cash flows over the anticipated holding period and the discount rate used to convert these cash flows to present values.
The discount rate can be defined as the required rate of return by the investor considering the particular property, or the rate of return required by investors in the particular marketplace for similar property investments of the same risk level. It should be noted that this required return depends on a number of market and property-specific factors.
When using the discounted cash flow model it is important to have in mind the following:
- All periodic cash flows that are used in the DCF model have to refer to periods of the same length (annual, semi-annual, quarterly, monthly). Usually, annual cash flows are used.
- The discount rate used must represent the discount rate that corresponds to the length of the period in which the cash flows refer to. For example, if cash flows are quarterly then the quarterly discount rate needs to be entered in the formula. Caution is needed here because discount rates are usually quoted in annual terms, and one might be tricked to use an annual discount rate with quarterly cash flows, in which case a very incorrect result will be obtained. Furthermore, caution is needed when deriving quarterly or other periodic discount rates from annual discount rates in order to take into account the compounding effect. The correct formula for deriving the quarterly discount rate (dq) from the annual discount rate (da) is:
dq = [ (1+ da)1/4 ] – 1
The correct formulas for deriving the monthly discount rate (dm) and the semiannual discount rate (ds) from the annual discount rate (da) are:
dm = [ (1+ da)1/12 ] – 1
ds = [ (1+ da)1/2 ] – 1
- The higher the discount rate used, the lower the PV and NPV of a property’s cash flows
The formula for the calculation of NPV, which takes into account investment cots (cash outlays) at time 0, is the following:
NPV = CF0 + CF1/(1+d) + CF2/(1+d)2 + ……..CFn/(1+d)n
In the above formula, CF represents the cash flow of each period within the investment analysis horizon, d the discount rate and n the last period of the investment horizon. As indicated earlier, the first cash flow CF0 represents the initial cash outlay or investment cost. The last cash flow CFn includes all income expected to be received during the last period of the investment horizon plus the anticipated sales price of the property at that point in time minus sales cost (usually the agent’s commission). See our post on exit cap rate for a more detailed discussion of how the future sales price for the property under consideration can be calculated. Once the net cash flows of a property have been estimated, for the periods 1 through n, the NPV function in Excel can be used to estimate the net present value of all cash flows including the initial cash outlay or investment cost (CF0).
The PV of a property’s expected cash flows represents actually the price that an investor with a required rate of return equal to the discount rate used in the model would be willing to pay at maximum for acquiring the particular property. This will be the maximum price because any price higher than that would result in a return lower than the one required by the investor. The formula for calculating the PV of a property’s cash flows is the same as the previous formula without the initial cash outlay CF0 :
PV = CF1/(1+d) + CF2/(1+d)2 + ……..CFn/(1+d)n
Once the net cash flows of a property have been estimated, for the periods 1 through n, the PV function in Excel can be used to estimate the net present value of these cash flows.
Use of the Discounted Cash Flow Model in Property Investment Analysis
The Discounted Cash Flow model is widely used in real estate, especially for the calculation of PV, NPV or the internal rate of return (IRR). The internal rate of return on an investment is actually the discount rate that renders the NPV of the expected cash flows equal to 0. So when the NPV of the cash flows is zero it means that the discount rate used is equal to the IRR that the investment would provide to the investor, if the property is purchased at the acquisition price used for the calculation of the NPV.
Typically the following apply usually when using the DCF model for the evaluation of real estate investments:
- The cash flows used represent after-tax cash flows. See our post Property Investment Basics: Operating Statement for a more detailed discussion of what revenues and expenses need to be taken into account for the calculation of after-tax cash flows of a property.
- The cash flow at time 0 is negative, as it represents investment costs and includes property acquisition costs, plus any pre-acquisition costs for due diligence, such as market studies, feasibility studies, legal, environmental studies, other consulting fees, etc. Subsequent cash flows might be negative as well, especially in the case of real estate development projects, where there are no revenues until the project is completed.
- The discount rate is applied to the net cash flow of each period, which is calculated as the sum of anticipated revenues and costs in each period. Notice that such costs and revenues will differ by property type and for any particular property depending on its characteristics. That is why special attention is needed when projecting property income and expenses in order to estimate these cash flows. Reliable projections of property income need to take into account the property’s lease rollover schedule, expiring leases and vacancy durations, as well as potential changes in market rents, which will affect income from new leases. Projecting market rents is not an easy task. Most reliable projections of market rents can be derived through advanced econometric models that take into account most likely changes in demand, supply and the way these changes affect rent adjustments in a particular segment of the property market.
The discounted cash flow model is typically used in the following cases:
- When the investor wants to estimate what is the maximum price he/she must pay in order to achieve a minimum or required rate of return. This price can be estimated by discounting the cash flows expected from the property over the holding period using the investor’s required rate of return as the discount rate. This is a present value (not a net present value} calculation since the initial cash outlay is not known and is to be determined.
- When the investor wants to estimate the expected return, and particularly, the internal rate of return (IRR) that a property investment will provide over the investment horizon if it is acquired at a given price. This is calculated by including the acquisition price in the cash flows to be discounted and estimating the discount rate that sets the NPV equal to zero. The so estimated discount rate is actually the internal rate of return (annual, monthly, quarterly, etc., depending on the length of the period to which the cash flows refer to). This can also be calculated in Excel using the IRR function and including the net cash flow line in the range of cells considered by the function.
The Discounted Cash Flow Model and Borrowing
Borrowing is used in most real estate transactions because, among others, it can increase the return on the investor’s equity under certain conditions. The discounted cash flow model is the same whether borrowed money is used to finance part of the property acquisition or not. What it does change is how the cash flows used in the DCF formula are calculated. In particular, if the analyst wants to take into account the effect of borrowing on the project’s NPV or IRR the periodic loan payments over the holding period need to be appropriately and fully incorporated in the project’s after-tax cash flows. In particular, this would include replacing any capital costs that are financed through borrowed money, with the respective periodic loan payments. For example, if acquisition costs of $20 million are financed by 50% with borrowed money, then the negative cash flow of $20 million at time 0 will be replaced by a negative cash flow of $10 million (50% of $20 million) and the loan payments in each period of the model will be also introduced as negative numbers. Also, the remaining loan balance needs to be subtracted from the last cash flow, which should incorporate the property’s anticipated resale price minus sales costs, as well as any rental or other income expected to be received during that period.
The return that incorporates the effect of borrowing is referred to as leveraged return. The return that is estimated assuming that the full property investment cost is covered by the investor’s own funds is referred to as unleveraged return. The calculation of the leveraged return represents a typical use of the discounted cash flow model since borrowing is commonly used in real estate investing.
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Kolbe, P. T., & Greer, G. E. (Author), Gaylon E. Greer. (2012). Investment Analysis for Real Estate Decisions, 8th Edition. Dearborn Real Estate Education.
Clauretie, T. M., & Sirmans, G.S. (2009). Real Estate Finance: Theory and Practice 6th Edition. Oncourse Learning.
Geltner, M., Miller, N. G., Clayton, J., & Eichholtz, P. (2013). Commercial Real Estate Analysis and Investments (with CD-ROM). Oncourse Learning
Sivitanides, P. 2008. Real Estate Investing for Double-Digit Returns. BookSurge Publishing.
Internal Rate of Return (IRR) and Property Investment
Property Investment Basics: Real Estate Return Measures
Exit Cap Rate: A Key Figure in Estimating or … Misestimating the Resale Price
How to Calculate a Market Cap Rate