There are very few things in the modern economic landscape that are widely used yet highly misunderstood. One of them is DCF – also known Discounted Cash Flow analysis for commercial real estate. The number of misconceptions that revolve around this useful metric is almost astounding considering the practicality and significance of it as far as real estate and commercial property analysis go. But before looking into that, let’s straighten out the kinks and clear the air as far as commercial real estate valuation and DCF analysis go.
What is Discounted Cash Flow Analysis for Commercial Real Estate Investments?
Simply put, it is a valuation method that seeks to determine the viability, profitability, and investment sustainability of an asset by considering various factors. And this includes but not limited to; the present cash flow of the investment, the projected future returns, and the scalability potential of the property. This way, it is possible to determine the estimated value of a prospective investment as accurately as it is economically possible. Considering the complexity of this valuation technique, DCF analysis is mainly applied in the valuation of multi-year commercial real estate property. In the simplest of terms, we are looking at the present annual return value that the asset can generate in relation to its expected future performance. Understanding the Basic Discounted Cash Flow Commercial Real Estate Model To understand the principles behind a basic DCF commercial real estate analysis, one must answer four fundamental questions that revolve around any property investment – regardless of its scale. For starters, i. How much money is going into the prospective investment? ii. When is this capital really injected into the investment? The time factor iii. How much money is expected to be churned out by the investment? iv. After how long are the returns of the investments expected? As you can see, it all boils down to being a time vs. capital affair. Which, of course, brings us to the following components of a commercial real estate DCF analysis.
The Estimated Cash Flows
For you to estimate accurately the net cash that can be churned out by an asset, you have to take into account all payments (cash outflows) done by the investor (you) and the entire income (cash inflow) from the property. In other words, the net estimated cash flows ought to take into account all the possible capital inputs that the investor undertakes when acquiring a given commercial property. This includes the initial investment (factor in the loan points and any other fees), the total expenses that are associated with acquiring or maintaining a given property, other capital outflows such as the principal repayments to the lender/bank and of course, the selling expenses that investor may incur upon liquidation of his investment. In other words, the selling expenses. On the other hand, the cash inflow estimates ought to factor in the annual income accrued from the investment and the net possible proceeds that can be recouped upon liquidation of an asset. It is only after weighing out these two factors that you can come into an almost conclusive analysis on whether or not it makes sense to purchase a given commercial real estate asset.
The Discount Rate
For the purposes of this discussion, the discount rate refers to the investor’s or proper owner’s Required Before Tax IRR. In other words, this is the rate of return on your equity investment. Sounds complicated, but it becomes easy to comprehend when you consider that it is comparable to the yields of other conventional market instruments such as corporate bonds, treasury bonds, and fixed deposit Savings accounts.
The Initial Cash/Capital Investment
As far as commercial real estate property is concerned; the initial capital investment is the total amount that the property investor has to pay the seller or realtor for him to gain the right to accrue future cash flows from a given real estate investment vehicle minus any mortgage proceeds. This will, collectively, include all the loan points, fees, renovation expenses or any repair (however minor) that have to be financed by the buyer or property investor.
The Holding Period
The holding period is the entire amount of time (in years) that investor will take to recoup his investment from the assumptive cash inflow that his newly invested asset will add to his income stream. In commercial real estate, a good holding period typically ranges between 5 to 15 years, for financial analysis practicality. However, anything beyond the 15-year threshold can be safely considered as being uneconomically viable.
The Annual Cash Flows
This is the total amount of money that a given commercial real estate property remits (before tax) in a given fiscal year. In a typical real estate investment portfolio, this is defined by the cash flow accrued before tax that is the total net result of the gross income less any property maintenance expenses or debt service. In this case, if the annual cash flow is negative, it means that the investor will have to shell out more dollars to keep the asset in operation and if the cash flow is positive, then the commercial real estate asset in question can be termed as economically sensible.
The Sale Proceeds
The sale proceeds here represent the entire amount of money that can be potentially recovered from the liquidation/disposition of the investment property. This is a cash flow estimate component that only shows up during the final stage of the holding period.
Now, with the various components of a conventional commercial real estate investment model out of the way, it is possible to explore the DCF analysis from a broad-spectrum point of view. As you may be already aware at this point, the discounted cash flow analysis points back to how good or sustainable an investment’s future cash flow will be – in relation to its present condition. We already know that the procedure for any commercial real estate valuation process encompasses three main steps; these are
a. ) Forecast or predict the expected cash flows in the future within a specified timeline.
b. ) Calculate the total expected/desired net return.
c. ) Discount the net future cash flow to the present at the desired rate of return on investment.
This implies that the above three steps coalesce around forecasting an investment’s future cash flow by creating an income projection that is also commonly termed as a commercial real estate proforma. That being said, establishing/analyzing the expected total return – sometimes referred to as the discount rate – typically varies from one investor to another. For instance, an individual investor will be more concerned with their desired discount cash flow, often content with a simple rate of return rather than the WACC (weighted average cost of capital). On the other hand, a corporate investor’s interest in commercial asset will be determined prominently by WACC. Nonetheless, when coming up with the projected discount rate, both classes of commercial real estate investors will account for the riskiness (or its perception/likelihood) of the investment in comparison to other alternative investment assets available for comparison.
After reviewing the anticipated cash flows and having established a suitable discount rate, the DCF analysis for commercial real estate projects can be further utiliized to calculate both the net present value (NPV) and the accompanying internal rate of return (IRR). These two are equally important measures of any commercial real estate project, as they aid in comprehending the performance value of commercial real-estate asset, yet they are also misconceived by most prospective property investors. Here is a brief on what those measures entail.
The Net Present Value (NPV)
The NPV is an investment tool/measure that an investor uses to determine whether the commercial real estate project is achieving a given target yield for the specific initial investment made. In other words, the Net Present Value quantifies any adjustment that has to be made, in relation to a given initial investment, to achieve a predetermined target yield. That is, assuming that all other factors are held constant. Mathematically, NPV is the arithmetic summation of all the cash flows in each semi-period of the entire holding period while being discounted at the investor’s desired rate of return.
The Initial Rate of Return (IRR)
The IRR of a commercial real estate investment is the best percentage rate returned for every dollar pumped into the project for each holding period. In layman terms, the initial rate of return is just another sophisticated definition for an interest rate. And ultimately, the Initial Rate of Return provides the speculative property investor a way of comparing his prospective alternative investments by their capital yields.
The Principle behind the NPV and the IRR
One might wonder, what is the principle behind these complex mathematical aspects of a commercial real estate project? For starters, recall that the DCF is an essential tool in any commercial property investor’s toolbelt. To make things easier, look at this way. The IRR is basically the investment rate of return that a commercial real estate investor expects to gain from a given property while taking into account all its project cash flows in the entire holding period. The NPV, on the other hand, hinges on the property’s discount rate. To reiterate, the discount rate is the investor’s desired or required rate of return on investment. In the case of an institutional investor, it is the weighted average cost on investment capital (WACC). For the individual investor, it is the practitioner’s opportunity cost of capital. So this implies that what the NPV shows is how far or near the mark we are from the required rate of return. And the combination of the IRR and the NPV tells us how much one needs to adjust their initial investment to achieve their target yield within a particular holding period.
How to Use the IRR and NPV to Evaluate the Economic Viability of a Real Estate Project
Bearing in mind that the NPV tells you the threshold of your initial capital investment to achieve a given rate of return and the IRR shows the net return on the project, factoring in the cash flow projections, consider the following quick example. Assume that you have $500,000 to invest and you’ve zeroed in on three potential commercial real estate assets where you can put your money. Completing an accurate DCF analysis for each project will give you the necessary insight on the best asset to acquire with your limited amount of capital. By comparing each of the property’s internal rate of return, you can identify the project that is likely to give you the highest return within your desired/intended holding period. Alternatively, given your required rate of performance, the NPV will pin point the asset with the highest/best value streams of projected cash flows.
In Closing – Why Shouldn’t You Overlook the Discounted Cash Flow Analysis?
It has been observed in the past that many commercial property investors and professional tend to overlook the rather complex discounted cash flow analysis indicators in favor of simplistic measures of an asset’s performance; good examples are cash-on-cash returns and the Capitalization Rate (CAP RATE). Essentially, there is nothing really wrong with such approach. However, as much as these basic ratios provide a rough picture of the projected value of an investment, they leave out or simply ignore the probability of the multi-period changes in an investment vehicle’s cash flows. And if we are talking about an extended holding period, say 10 or 15 years, this seemingly minor factor can lead to very different results. To some extent, this has been one of the leading causes of most ill-informed commercial property investments that some of us are grappling with despite shelling out top dollars to acquire what seemed as very ripe and promising investment vehicles at first. If anything, the over-used phrase ‘time changes’ does not apply any better than in the commercial real estate market. So, what the DCF analysis does is take into consideration all the projected cash flows in the asset’s holding period to give you a precise picture of the investment health of the property. As such, it is a crucial instrument in any commercial property investor handbook that shouldn’t be overlooked at any cost whatsoever.