Discounted Cash Flow Analysis: Part 2 Revised

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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©2011 by The Falbey Institute for the Development of Real Estate

Return on Investment in Real Estate: Discounted Cash Flow Analysis

In recent posts to this blog, we’ve looked at relatively simple methods for measuring the return on invested funds.

·        The cash-on-cash method measures the rate of return, expressed as a percentage, on invested equity only.

·        The capitalization rate, or cap rate, measures the rate of return on all capital invested, debt and equity. It also is expressed as a percentage.

While these methods are commonly used in the industry, they leave much to be desired. Primarily, they measure return for a single annual period, whereas most real estate investments or projects experience a multiyear cycle of development and operation. If your capital is at risk for a period of several years, shouldn’t your measure of return reflect this? Can you really understand and measure return on your investment by looking at a single year’s activity, such as the first year at stabilization?

Another issue is the time value of money. Is a dollar received in Year Ten’s cash flow worth as much as a dollar received in Year One’s cash flow? If you invested $100,000 today and received $200,000 within the first year, did you double your money? What if it took five years to get the $200,000? If you fail to see the difference, ask yourself this question: suppose you won $10,000,000 in your state’s lottery, but the state asked you if it could keep the funds for a couple of years then pay you – no interest accrues. Would you say, “Sure!”?  Of course you wouldn’t. It’s the “bird in hand theory”. A dollar received today is worth more than a dollar received somewhere down the road, because, among other things, dollars lose purchasing power over time, inflation eats away at it’s value, there is the cost of lost opportunities, and there is the risk of default or nonperformance. This is the essence of the time value of money.    

So, the question is: Given the effects of the time value of money, is there a way to measure return on investment over a multiyear period? The answer is yes, using discounted cash flow analysis. 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).

There are three principal discounted cash flow methods utilized in real estate:

·        Mortgage Amortization: In real estate, this essentially is a sinking fund in which regularly scheduled payments containing principal and interest are made over a specified period of years so that the final payment completely satisfies the mortgage debt.

·        Net Present Value (NPV) :  Measures and compares the attractiveness of alternative investment opportunities. This actual defies conventional wisdom by proving that you really can compare apples to oranges.

·        Internal Rate of Return (IRR): Calculates the return earned on the invested capital over the life of the investment, not just the initial year.

In this discussion, we’ll concentrate on NPV and IRR.

The components of NPV and IRR calculations 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. Since the recent financial meltdown, investors and lenders are more conservative in underwriting the forecasted and terminal cash flows.  Thus, in-place cash flows are a larger portion of the calculation – meaning cap rates have to rise, which pushes purchase prices (values) down if the investments are going to pencil out.

The next posting to this blog will discuss Net Present Value specifically.

Connect with us: 

visit FaceBook; Twitter, LinkedIn, YouTube, the Falbey Institute for the Development of Real Estate. The Institute's web site currently is undergoing revision, and we apologize for any inconvenience experienced.

©2011 by The Falbey Institute for the Development of Real Estate