Discounted Cash Flow Analysis

11 Replies

Quick question on discounted cash flow analysis for anyone who has any input on the topic.

Say we are dealing with the following hypothetical scenario:

T12 Actual Income: 1,000,000

T12 Actual Expenses: 475,000

T12 NOI: 525,000

Then say I'm assuming a 2% NOI increase per year for the next 5 years:

Yr1 NOI = 525,000

Yr2 NOI = 535,500

Yr3 NOI = 546,210

Yr4 NOI = 557,134

Yr5 NOI = 568,276

So, this gives us:

Year 1 CF = 210,000

Year 2 CF = 220,500

Year 3 CF = 231,210

Year 4 CF = 242,134

Year 5 CF = 253277 + 2,300,000 = 2,553,277

Total CF = 3,457,121

CFs were derived because my debt service on this property is  could be roughly 315,000 per year (5,830,000 purchase price with 25% down pmt and 6% interest over 30yr amortization).

That would leave roughly 4,000,000 as pay-off for the loan after 5yrs. of making P&I payments.

With a yr5 NOI = 568,276, that would give me a property value of roughly 6,300,000 using the same 9% cap that I bought with for simplicity's sake and a sale profit of roughly 2,300,000 (as reflected in the total Yr5 CF above).

Then say throughout my ownership I spend 500,000 total on cap ex to fix roofing, hvac units, etc. so say it worked out to 100,000/yr deducted from my CFs:

Now those numbers are fine and dandy, but I'm looking to see if I'm correctly applying discounted cash flow analysis as follows:

Actual CFs                               Discounted CFs

110,000                 (Yr1)                 98,113

120,500                 (Yr2)                 96,244

131,210                 (Yr3)                 94,128

142,134                 (Yr4)                 91,792

2,453,277              (Yr5)                 1,807,957

2,957,121             (Total)               2,188,234

*These CFs include cap ex deductions of 100k/yr

So, discounting CFs and considering cap ex gives me a difference of: 768,887 between the two columns.

Does this mean my IRRs are as follows?

IRR (actual CFs): 12.29%

IRR (discounted CFs): 5.06%

That's a huge difference and seems like the investment isn't worthy when considering discounted CFs. Or am I calculating discounted CFs wrong/using them wrong when trying to analyze a property?

If I'm out in left field I hope someone can help get me back into position as I'm here to learn.

***This is also all pre-tax as well.



Originally posted by @Account Closed :
Originally posted by @Richard Haiber:

Quick question on discounted cash flow analysis for anyone who has any input on the topic.

You only use 'net cash flow' for computing IRRs, net present value etc. On rentals you want to use net operating income.

You might want to look at this to see how others are deriving their net operating income: http://www.biggerpockets.com/renewsblog/2013/01/19/real-estate-math/

Didn't realize that I should only be applying DCF to my NOI (rather than the CFs after debt service and capex, etc.).

I understand the differences between income, expenses, NOI and CF after debt svc, etc. What I've been doing is taking the time to learn how to compute DCF analyses on properties but needed a little guidance on the application in practice.

Also, when you typically calculate a DCF for a property how are you personally determining what you'll use as your discount rate? Because depending on what discount rate you use, it will greatly affect your calculations. I understand you should use the "opportunity cost of capital" so am I just using whatever my desired rate of return per year happens to be for the investment?

Thank you for your response, it's greatly appreciated!

Originally posted by @Richard Haiber :

...Also, when you typically calculate a DCF for a property how are you personally determining what you'll use as your discount rate? Because depending on what discount rate you use, it will greatly affect your calculations. I understand you should use the "opportunity cost of capital" so am I just using whatever my desired rate of return per year happens to be for the investment..?

Thank you for your response, it's greatly appreciated!

The discount rate typically is the 'cost of funds'. Another way to look at it is the rate of return required by the investor to invest in the project. Different investors may require a different rate of return for their money based on the nature of the project and the perceived risk. The discount rate will typically only affect the Net Present Value NPV and not the IRR. The IRR also does have to be higher than the discount rate for the deal to make sense.

Richard -

Looks like a couple of points of clarification might be in order:

You can do an IRR calculation using either the annual NOI along with the sale-year reversion (i.e., selling price). This is called an unlevered IRR as is typical of the method used by appraisers.

Alternatively, you can use the annual cash flows along with the proceeds of sale (i.e., the net after mortgage payoff). This is called the levered IRR and is more commonly used by investors because they want to compare different potential property investments that they intend to finance.

In either case, you must also take into account the initial cash investment. Without that, you cannot perform a correct IRR computation. You do not take individual discounted cash flows and then perform the IRR calculation, because that would be discounting the same cash flows twice.

In regard to the discount rate for a DCF pro forma, understand that the purpose of the IRR calculation is to find the exact discount rate that would make the present value of the future cash flows equal to what you paid for them. In other words, what is the rate that makes the NPV equal zero? Or yet another way of saying this, what is rate that makes the PV of the future cash flows equal to the cash invested?

It makes no difference whether the property is residential or non-residential. The entire DCF / IRR process is an analysis of the income stream and can be applied to any investment that involves an initial cash commitment, periodic cash flows, and a final cash from disposition of the investment.

Hope this helps.

Frank

Originally posted by @Frank Gallinelli :

... understand that the purpose of the IRR calculation is to find the exact discount rate that would make the present value of the future cash flows equal to what you paid for them....

I hope that doesn't confuse him as it seems a very narrow way to look at the purpose of the IRR.

The IRR by definition is the discount rate that makes project cash flows equal the investment but some users of the IRR may view the use and purpose of the IRR as an investment evaluation tool for measuring the profitability, efficiency and quality of an investment compared to other alternatives.

@Kenneth G.  Point taken. "Purpose" was not the best word to use there. I was looking for various ways to describe the process. Indeed, I agree that most investors would view the purpose as investment valuation and comparison to alternatives.

Originally posted by @Frank Gallinelli :

Richard -

Looks like a couple of points of clarification might be in order:

You can do an IRR calculation using either the annual NOI along with the sale-year reversion (i.e., selling price). This is called an unlevered IRR as is typical of the method used by appraisers.

Alternatively, you can use the annual cash flows along with the proceeds of sale (i.e., the net after mortgage payoff). This is called the levered IRR and is more commonly used by investors because they want to compare different potential property investments that they intend to finance.

In either case, you must also take into account the initial cash investment. Without that, you cannot perform a correct IRR computation. You do not take individual discounted cash flows and then perform the IRR calculation, because that would be discounting the same cash flows twice.

In regard to the discount rate for a DCF pro forma, understand that the purpose of the IRR calculation is to find the exact discount rate that would make the present value of the future cash flows equal to what you paid for them. In other words, what is the rate that makes the NPV equal zero? Or yet another way of saying this, what is rate that makes the PV of the future cash flows equal to the cash invested?

It makes no difference whether the property is residential or non-residential. The entire DCF / IRR process is an analysis of the income stream and can be applied to any investment that involves an initial cash commitment, periodic cash flows, and a final cash from disposition of the investment.

Hope this helps.

Frank

I appreciate your time to respond. Its worth more than its weight in gold.

Now, considering that, does the following now make sense?

If I'm still missing a key aspect of the application of these concepts could you provide a simple example done correctly so I can see the process I need to be following?


https://onedrive.live.com/redir?page=view&resid=A3...









Originally posted by @Frank Gallinelli :

@Kenneth G.  Point taken. "Purpose" was not the best word to use there. I was looking for various ways to describe the process. Indeed, I agree that most investors would view the purpose as investment valuation and comparison to alternatives.

 Frank,

Ive still been workign wih and getting efficient with DCF since my last post.

A question I'm asking myself now regards the discount rate. We factor in an appropriate amount of risk into what we use for our discount factor. Now when I'm looking at a property (whether I'm assuming 5yr, 10yr, etc holding periods), doesnt the perceived risk increase each year that passes? Isn't the income stream of a property much more "guaranteed" in yr1 than it will be in yr10? So shouldnt I be adjusting my discount factor each year? Or do you use an identical discount factor for all years on the same property?

@Richard Haiber

It's my opinion that you have done a pretty good job thinking through the expenses, operating costs, income projections, and final sales price. I know little about the building and probably can't provide much input on those assumptions.

That said, it's my opinion that you are confusing yourself and making this financial analysis more complicated than it needs to be. Instead, it could be portrayed slightly differently and more simply to your advantage:

You must factor in your own cash outlay into your assumptions for the value created for the purchase of this property. Given the information provided ((5,830,000 purchase price with 25% down pmt), your cash outlay is $1,457,000.

Year Zero Cash Flow: - $1,457,000

Year One Cash Flow: $110,000

Year Two CF: $ 120,000

Year Three CF: $ 131,210

Year Four CF: $ 142,134

Year Five CF: $ $2,453,277

Net Cashflow: $ 1,499,121

The IRR on this set of cash flows is 17%.

You do not need to apply an IRR to discounted cash flows. Now, I'm confused as to where your discount rate came from. When I personally value investments using financial analysis I like to use a Cost of Capital of 10%.

Why? Because the only thing you know for certain about my financial models and guesses into the future is that they are wrong. The only thing the model tells me for sure is that "if everything goes according to my plan, this either will or won't work". In the case of real estate, the plan better be pretty darn good and work by a wide margin, else why bother!

Now, in assuming a discount rate, 10% is an easy number to work with and fairly close to the stock market. If you can’t beat 10% returns, why would you bother investing in real estate? If you beat 10% by a wide margin, then great! You can make the decision you need to from your DCF model. But I digress...

Discounted at 10%, the Present Value of your cash flows is thus (rounded to the nearest dollar):

Year Zero DCF: $1,457,500

Year One DCF: $ 100,000

Year Two DCF: $99,174

Year Three DCF: $98,580

Year Four DCF: $97,079

Year Five DCF: $1,523,292

Net Present Value at 10% Cost of Capital: $460,625

What this analysis tells us is that if your assumptions are correct, you will make somewhere in the ballpark of $450,000 more dollars on this property than if you just dumped your money in the stock market.

Hope this helps!

Originally posted by @Richard Haiber :
Originally posted by @Frank Gallinelli:

@Kenneth G.  Point taken. "Purpose" was not the best word to use there. I was looking for various ways to describe the process. Indeed, I agree that most investors would view the purpose as investment valuation and comparison to alternatives.

 Frank,

Ive still been workign wih and getting efficient with DCF since my last post.

A question I'm asking myself now regards the discount rate. We factor in an appropriate amount of risk into what we use for our discount factor. Now when I'm looking at a property (whether I'm assuming 5yr, 10yr, etc holding periods), doesnt the perceived risk increase each year that passes? Isn't the income stream of a property much more "guaranteed" in yr1 than it will be in yr10? So shouldnt I be adjusting my discount factor each year? Or do you use an identical discount factor for all years on the same property?

 @Richard Haiber  Richard, The discount rate for a DCF -- at least as it applies to income property -- is an item that doesn't seem to present an universally agreed-upon appraoch or definition. Most real estate investors that I've dealt with have used the opportunity cost of their capital. In other words, what return could they anticipate from an alternative investment (real estate or other) having essentially the same risk profile? I've not encountered the use of a variable discount rate (although it's an interesting point that you raise) -- perhaps because an investor looking at an opportunity cost is most likely considering the overall return on an alternative investment. I guess my answer -- like discount rate itself -- is mostly speculation. ;)

Originally posted by @Frank Gallinelli :
Originally posted by @Richard Haiber:
Originally posted by @Frank Gallinelli:

@Kenneth G.  Point taken. "Purpose" was not the best word to use there. I was looking for various ways to describe the process. Indeed, I agree that most investors would view the purpose as investment valuation and comparison to alternatives.

 Frank,

Ive still been workign wih and getting efficient with DCF since my last post.

A question I'm asking myself now regards the discount rate. We factor in an appropriate amount of risk into what we use for our discount factor. Now when I'm looking at a property (whether I'm assuming 5yr, 10yr, etc holding periods), doesnt the perceived risk increase each year that passes? Isn't the income stream of a property much more "guaranteed" in yr1 than it will be in yr10? So shouldnt I be adjusting my discount factor each year? Or do you use an identical discount factor for all years on the same property?

 @Richard Haiber  Richard, The discount rate for a DCF -- at least as it applies to income property -- is an item that doesn't seem to present an universally agreed-upon appraoch or definition. Most real estate investors that I've dealt with have used the opportunity cost of their capital. In other words, what return could they anticipate from an alternative investment (real estate or other) having essentially the same risk profile? I've not encountered the use of a variable discount rate (although it's an interesting point that you raise) -- perhaps because an investor looking at an opportunity cost is most likely considering the overall return on an alternative investment. I guess my answer -- like discount rate itself -- is mostly speculation. ;)

 Frank, since my last post I read "What Every RE Investor Needs To Know About CF".

Read thru it, took notes and after re-reading my posts it's funny how much more complicated I was making NPV, IRR and discounting CFs. I learned a lot in a relatively few number of pages. Enough to where my property evaluation perspective has changed and it has me recognizing how one-dimensional (and deceptive!) it is evaluating a property strictly on cap rates or COC returns. Viewing properties as a stream of CFs over an entire holding period and the timing of these CFs is what gives you a sign of the health of an investment.

My next task is to work on the skill (art?) of being able to forecast based on the property type and market conditions. That seems to be the most important aspect of anything regarding DCF while it's also the most tricky. My future property evaluations should include a conservative DCF, moderate DCF and aggressive DCF. If at that point I can look at the lower end estimates of the property's future potential and still like the investment then it's an investment at least worth looking into.

Thanks for your responses on here and I also appreciate the knowledge I took from your book.

Scott, thanks for your response. Posters that are willing to help out and share things they've learned are what make this website worth visiting!

Create Lasting Wealth Through Real Estate

Join the millions of people achieving financial freedom through the power of real estate investing

Start here