Discounted Cash Flow Valuation Guide for Commercial Real Estate
Discounted cash flow valuation, also known as “DCF”, is a popular formula used for valuing commercial real estate assets.
The idea is simple: a dollar today is worth more than a dollar tomorrow. For commercial real estate investors, this means that you need to remember that the value of an asset is the sum of all future cash flows that have been discounted for risk.
The likelihood and timing of future cash flows will impact the price that you are willing to pay for a commercial real estate asset today, making this formula an essential tool for every savvy real estate investor.
The riskier the cash flow stream is the higher the discounted rate will be for it. Cash flow streams that have a higher level of certainty will be given a lower discount rate.
Understanding how DCF works will help you make smart commercial real estate investments and give you a greater probability of making an investment that will generate a larger return.
DCF or Capitalization Rates?
Another common term you may have heard of is capitalization rates. Perhaps you are thinking that if you are using capitalization rates you don’t need to use or understand DCF.
Many commercial real estate investors rely on capitalization rates as a shortcut to valuing assets. However, capitalization rates have notable limitations in comparison to DCF.
DCF analysis is a more comprehensive and accurate way to value an asset. In the next section, we will explain how you can do a DCF calculation and you will start to see why it is a more accurate formula and therefore more useful.
The Basic DCF Formula
Commercial real estate investors can use a simple formula to calculate the DCF of a property.
You will need to have a few figures ready before you start your DCF analysis. You will need to have:
- initial cost of the property
- interest rates
- year-by-year expenses and profits
- holding period
The formula looks like this:
CF = Cash Flow
r = Discount Rate (WACC)
Let’s take a look at an example, with basic round numbers.
If you wanted to calculate the cash flow stream of $100 that extends for three years discounted at 8%, the formula would be as follows:
Present Value of Year 1 Cash Flow:
Present Value of Year 2 Cash Flow:
Present Value of Year 3 Cash Flow:
Present Value of All Cash Flows: $257.71
What does this final figure mean? In simple terms, an investor that purchases this asset for $257.71 will earn an 8% return on this cash flow stream.
The discount rate is the necessary return that an investor would need to generate for the level of risk assumed.
The important aspect of this formula that gives you a higher level of accuracy than capitalization rates is that it takes into account the level of risk assumed. Higher risks have higher discount rates, and lower risks, lower rates.
The formula may seem a little complicated the first time you approach it. However, Excel and Google Sheets make the calculations simple. You can simply input the cash flows and use the ‘=NPV’ formula to get the net present value of any annual cash flow stream.
How Is Cash Flow Determined For a Commercial Real Estate Asset?
A key part of the DCF formula is the CF – cash flow. But how do you work out the cash flow for a commercial real estate asset? Well, it’s simpler than you might think.
An asset’s cash flow is calculated by looking at both annual cash flow and sales proceeds – these are known as the terminal or residual value.
This value is determined by dividing the net operating income in the year following the forecast hold period by the future capitalization rate.
As explained above, the capitalization rate does not give the most accurate picture. Therefore you balance it out with a number of other figures.
You will review the residual value versus the replacement cost, the future buyer’s internal rate of return, and sales comparable to the property invested in to calculate what the sales price at the end of your hold period will be.
What is the Appropriate Discount Rate?
Above we looked at the numerous variables that can affect future cash flow. The more there are and the longer the holding period is the less accurate they can become.
Variability of cash flows will be a major influencer in calculating the appropriate discount rate.
The risk of the asset and the business plan will both impact the level of the overall risk of the cash flow which in turn impacts the discount rate.
To give you a general idea, unleveraged discount rates for real estate normally come in somewhere between 6% and 12%.
The discount rate can be thought of as the expected rate of return that you will see on the property before using leverage.
The risk of the asset can be thought of in terms of the type of real estate property you are investing in.
For example, hotel real estate often has a higher asset-level risk than multi-family properties due to higher operating leverage and shorter stays for occupants – per night for apartments versus per year for multi-family.
Business plan risk is another factor to review. This looks at the investment strategy behind the project.
For example, investing in a ground-up development requires substantial planning, effort and cost to achieve the end result. Whereas, an asset with a tenant who has a decade left on their lease requires significantly less effort and has fewer inputs that could potentially go wrong. Therefore the latter would have a lower discount rate.
Example of Discount Rate For Commercial Real Estate
Let’s take a look at an example.
Below we look at the DCF analysis for an apartment building versus that of a hotel. Both assets are forecast to generate $100 of cash annually and a residual value is calculated using the assumption that the capitalization rate upon sale in the future is equal to the discount rate being used.
|Apartment Annual Cash Flows|
|Hotel Annual Cash Flows|
An Inexact Science
While DCF is a very useful formula for commercial real estate investors, it is important to remember that it is not an exact science.
It is possible that many of the forecast outcomes will be notably different than your original projections.
This can go both ways. In some cases, you will find the results exceed expectations and in others, it will be the opposite and there will be underperformance.
One of the main reasons that you need to have this considered in your investment plans is to avoid the downfall of putting all your eggs in one basket.
Diversifying your portfolio across more properties means the variance of one individual property that might underperform has a small impact on your overall portfolio.
To Sum Up
Once you start to understand the basics of cash flow in commercial real estate and use the DCF analysis effectively, you will realize that it is an invaluable tool for making smart investment choices.
While it is not a perfect formula, the DCF analysis helps you calculate the expected cash flows coming in and out of a property, at a risk-free rate, over the forecasted holding period and determine the future value of their cash flow projections.