Part 1 of this discussion of discounted cash flow analysis, or DCF, was a general description of what it is and why it has significance for real estate investment and development. It is a means to measure or assess the present value of cash flows to be generated by the property (investment) in future periods (c.f., years of ownership). Here’s another way of looking at it:
· The initial investment to acquire or develop an income generating property is made today, in today’s dollars
· This property will generate income (primarily from rent) over a multiyear period of development and operation
· The dollars to be generated in these future year cash flows do not have the same value as today’s dollars
· The further out each succeeding year is, the less value the dollars generated in that year have in comparison to today’s dollars
· Therefore, these future cash flows have to be discounted (by some means) in order to determine their real value in today’s dollars
This process is called net present value or NPV. Because any type of investment – real estate or otherwise – is expected to produce cash flow, even if it’s simply a sale in a future year, NPV can be applied. As a consequence, NPV provides a means of comparing alternative investment opportunities to determine which one is likely to produce the greatest value or return on dollars invested today. Therefore, you can compare a real estate investment to an investment in pork belly futures, fine art, precious metals, equities, literally anything.
The components of NPV calculations for real estate are the following cash flows, positive and negative:
· The initial capital invested (negative)
· Subsequent capital investments (negative
· In-place (existing rents - positive)
· Forecasted (predicted future rent increases - positive)*
· Terminal or reversion (net sale proceeds - positive)*
*These latter two are highly speculative and not given much weight in today’s market.
First, let’s clear up any confusion about present value versus net present value. Present Value is a short-form methodology used to evaluate a property using its current-year NOI: Present Value (PV) = NOI ÷ cap rate. This is the essence of the cap rate that was discussed in an earlier posting to this blog.
Net Present Value, as noted above, is the value today of all future cash flows, positive and negative, to be generated by the project as discounted by the required rate of return (i.e., hurdle rate) minus the cost of acquiring the property. The discount or hurdle rate is a rate that reflects opportunity costs, inflation, and risks accompanying the passage of time. It is personal to every investor because each person assesses and weights risks differently.
NPV calculations produce a number, not a percentage. The key to interpreting the results of these calculations is in the nature and amount of the number produced:
· If NPV > 0, the financial value of the invested assets would be increased, (i.e., the return on invested capital is greater than the investor’s hurdle rate)
· If NPV = 0, the financial value of the invested assets would neither increase nor decrease, (i.e., the return on invested capital is equal to the investor’s hurdle rate)
· If NPV < 0, the financial value of the invested assets would be decreased, (i.e., the return on invested capital is less than the investor’s hurdle rate)
For example, suppose an investor is seeking a minimum return on capital invested (hurdle rate) of 15%. He or she has an opportunity to purchase a property that requires an investment $500,000 and will produce $125,000 per year in cash flow before taxes. Suppose also that the investor intends to sell the property after five years and expects the sale to net $1,000,000.
Will the investment produce a return at least equal to 15% under these circumstances? While the calculation requires use of a programmable financial calculator or spreadsheet software, the answer is “yes”. The calculation produces the number 416,196. Because we’re dealing with cash, this number actually is expressed as $416,196 and it’s a positive number. It means that the investment will produce the 15% return AND an additional $416,196. In fact, the actual rate of return (Internal Rate of Return or IRR) is 35.04%.
So, what actually happened here? Each year’s cash flow was discounted from the time it was (will be) generated back to the present using a discount rate of 15% (the investor's hurdle rate). Those respective annual cash flows, as discounted at 15%, have a value today of: $108,696, $94,518, $82,189, $71,469, and $559,324. That’s a total of $916,196. After deducting the initial capital outlay of $500,000, the result (NPV) is $416,196.
The next posting to this blog will discuss the Internal Rate of Return - IRR.
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