If underwritten properly, commercial real estate can outperform other asset classes over time, but it’s not always the magical cash cow some new investors think it is.
Volatile credit environments can send even seemingly well-structured deals into a tailspin. That’s why you need to step back from surface-level projections and test your assumptions more critically against downside scenarios.
The Discounted Cash Flow (DCF) method is one of the valuation approaches you can use for long-hold projects.
This model lets you estimate a property’s value by projecting how much income it will produce over time — not just from rent but also from operations and eventual sale — and then translating that future income into today’s dollars.
Your DCF Cheat Sheet
So how do you quickly apply the DCF method? First, estimate how much income the property will likely generate each year.
This includes the NOI each year (from rent and other property operations) and a reversion value at exit (estimated sale price of the property when you sell it at the end of the holding period).
Then, for each future year, adjust the value of that income based on how far into the future you expect to receive it and how uncertain it is.
The riskier the deal or the higher the return you need to justify the investment, the more sharply you should reduce the value of that future income.
Once you’ve done that for each year, add everything up. The result is the property’s present value — what those future earnings are worth today.
Why is it important to review the DCF before investing in a commercial property?
Because DCF analysis helps you see whether the potential returns are worth the risk and initial cost. With this information, you can understand a property’s profitability over time.
If you’re comparing multiple properties on an equal basis, you can use the DCF to identify which of those opportunities have the best long-term value.
The DCF also helps highlight the main performance drivers that can affect your investment’s success (such as rent growth and occupancy rates).
What’s more, a DCF analysis lets you see a CRE property’s expected cash flows and risk-adjusted returns more transparently. This is why lenders and equity partners expect to see it as part of underwriting and due diligence.
What can the DCF tell you about a commercial property?
Projected rental income
Using DCF, you can estimate how much rental income a property will produce based on factors such as current lease agreements and local market rents. You can also include rent growth assumptions to project income over the holding period.
Capital expenditures
Did you know that a DCF model can help you plan for major one-time costs (such as roof replacements and HVAC upgrades) and schedule them into the years they’re expected to occur?
These capital expenditures reduce cash flow in the years they hit but may improve long-term value, so including them in your forecast helps you see their impact on returns and net present value.
Operating expenses
You can also estimate a CRE property’s recurring costs (from property taxes to insurance and management fees) using DCF analysis, so you can adjust these expenses for inflation and understand how they might change throughout the investment period.
Reversion value
The DCF framework includes an estimate of what the property could sell for at the end of your holding period (reversion value), which helps you understand how much of your return depends on the resale (not just the income along the way).
How do you apply the DCF method in commercial real estate?
- Project unlevered cash flows. Estimate the property’s annual NOI, capital expenditures, and leasing costs over a typical 5–10 year holding period.
- Choose a discount rate that reflects your cost of capital and the risk of the investment.
- Discount each year’s cash flow. Adjust future cash flows to their present value using the discount rate.
- Estimate the property’s value at sale (usually by applying a cap rate to the final year’s NOI) and discount that too.
- Sum all discounted cash flows and the terminal value to get net present value or NPV.
- Compare NPV to your initial investment. Calculate the internal rate of return or IRR and equity multiple to evaluate performance.
- Stress-test key assumptions like rent growth, exit cap rate, and vacancy to see how outcomes change.
Be sure to consider these factors in your calculation:
- What you’re putting in up front (initial cost) – That could be the full purchase price or just your equity contribution, depending on whether you’re modeling unlevered or levered cash flows.
- How long you plan to hold the property (holding period) – Most commercial investments assume a 5 to 15-year horizon depending on your exit strategy.
- Your target return – This becomes your discount rate — the rate you’ll use to value future cash flows in today’s terms.
- Expected income – Project the rental income each year based on lease terms, market rents, and expected rent growth.
- Operating costs and capital expenses – Include annual expenses like taxes, insurance, repairs, and any major renovations.
- The sale value at exit (sale profit) – Estimate how much you’ll sell the property for at the end of the holding period, usually by applying a cap rate to final-year NOI.
Keep in mind that several of these inputs require an estimation, particularly maintenance costs and future property values. You can ground those assumptions by examining comparable properties in the same market.
Computing the property’s net present value is straightforward when you’ve finalized your assumptions and discount rate.
There are quite a lot of online tools and financial software programs available these days to make DCF calculations quick and reliable, so you can evaluate multiple properties efficiently.
Example of using DCF in real estate investments
To illustrate, imagine you have $500,000 to invest. You can either buy a residential property you expect to sell for $750,000 in 10 years or put that same amount into a real estate investment trust (REIT) projected to return 10% annually over the next decade.
If you use 10% as your discount rate, you’d calculate the present value of the home’s future cash flow ($750,000) as $289,157.47.
This means that in today’s terms, the house is worth far less than the REIT investment, which could generate nearly $800,000 over the same period.
In this simple scenario, the DCF analysis suggests that the REIT provides better value and risk-adjusted returns compared to buying the house.
Now, let’s apply DCF to a commercial property example.
Imagine buying an office building that’s currently 85% occupied for $10 million, with average in-place rents of $25 per square foot.
You project 3% annual rent growth and expect occupancy to rise to 95% within the first two years. You also estimate that operating expenses will start at $8 per square foot and will grow by 2% annually.
In year two, you plan to invest $500,000 in renovations to upgrade tenant spaces and common areas, and after a 7-year holding period, you expect to sell the property at a 6.5% cap rate.
Based on a DCF analysis using an 8% discount rate — and factoring in net operating income throughout the hold, capital expenditures, and the projected sale proceeds — the investment results in a net present value (NPV) of $12.5 million.
This corresponds to an IRR of 14% and an equity multiple of 1.8x.
With these results, you can easily compare this property to other opportunities and decide whether the projected return meets your investment goals.
Besides showing the expected profitability, the DCF highlights where small changes in assumptions can meaningfully impact value, such as rental growth or exit cap rates.
What mistakes in analyzing the DCF of commercial properties should you avoid?
Mistake: Projecting unrealistic rent growth
Don’t assume 5% annual increases when the market averages only 2% to %. Thus, can inflate your NPV and make the deal look better than it is.
Mistake: Overestimating terminal value
Are you using an exit cap rate that’s too low or ignores market risk? If yes, then you may be overstating the property’s resale price at exit.
Mistake: Forgetting to account for key costs
Don’t forget to include capital improvements, tenant improvement allowances, or lease-up costs. Otherwise, your cash flow model may end up looking stronger than it should.
What are the best practices for using DCF analysis in commercial real estate?
- Have a clear understanding of the property’s existing cash flows and local market dynamics.
- Perform a comprehensive due diligence on expenses and potential financial or operational risks.
- Include sensitivity analysis to test how changes in assumptions, such as rent growth or vacancy, can affect projected returns.
- Base your inputs on realistic, market-supported assumptions for rental growth and exit capitalization rates.
- New data will be available during the holding period, so be sure to update your DCF model regularly.
- Use DCF alongside other valuation techniques, such as direct capitalization and comparable sales. This will help you confirm your property value estimates.
- Run multiple scenarios, including base and downside cases, so you can understand potential performance ranges.
Reach out to our team at Private Capital Investors for more financing guidance and to explore flexible loan options. Call 972-865-6206.
