A:

Discounted cash flow analysis, or DCF, is very commonly used in evaluation of real estate investments, although determining the discount rate involves a number of variables that may be difficult to predict accurately. Discounted cash flow analysis is a valuation method that seeks to determine the profitability, or mere viability, of an investment by examining projected future income or cash flow from the investment, and then discounting that cash flow to arrive at an estimated current value of the investment. This estimated current value is commonly referred to as net present value, or NPV. For evaluation of real estate investments, the discount rate is commonly the desired or expected annual rate of return.

For real estate investments, the following factors need to be included in the calculation:

Initial cost - Either the purchase price or down payment made on the property.
Financing costs - The interest rate costs on any initial or expected financing.
Holding period - For real estate investments, the holding period is generally calculated for a period of between five and 15 years, although it varies between investors and specific investments.
Additional year-by-year costs - These include projected maintenance and repair costs; property taxes; and any other costs besides financing costs.
Projected cash flows - A year-by-year projection of any rental income received from owning the property.
Sale profit - The projected amount of profit the owner expects to realize upon sale of the property at the end of the projected holding period.




A number of variables must be estimated in the DCF calculation; these can be difficult to pin down precisely, and include things such as repair and maintenance costs, projected rental increases and property value increases. These items are usually estimated using a survey of similar properties in the area. While determining accurate figures for projecting future costs and cash flows can be challenging, once these projections and the discount rate are determined, the calculation of net present value is fairly simple and computerized calculations are freely available.

RELATED FAQS
  1. What are the differences between investing in real estate and stocks?

    Invest in real estate by purchasing physical property or buildings, or invest in stocks by buying a claim to a company and ... Read Answer >>
Related Articles
  1. Investing

    Learn to Value Real Estate Investment Property

    Make sure you know what your real estate investment is worth before you sign the ownership papers. Learn what capitalization rate means to your net operating income.
  2. Investing

    How interest rates affect property values

    Interest rates have profound impact on the value of income-producing real estate property. Find out how the rise and fall of interest rate affects property value.
  3. Investing

    Evaluate Stock Price With Reverse-Engineering DCF

    This is a more accurate method to use when trying to find a target price for a stock.
  4. Investing

    Value Investing: Why Investors Care About Free Cash Flow Over EBITDA

    Examine value investing philosophy and methodology to see why free cash flow is more important than EBITDA in pure intrinsic value calculation.
  5. Investing

    4 ways to value a real estate property

    Here are several approaches to evaluate real estate properties for investment purposes.
  6. Investing

    A Guide to Real Estate Investing

    Investing in real estate is a popular choice for good reasons, but it's more complicated than owning your typical stocks and bonds.
  7. Investing

    Flipping houses: Is it better than the buy-and-hold strategy?

    Real estate investors can choose flipping or buying and holding a property. Find out the pros and cons of each, and which real estate investment strategy may best for you.
  8. Investing

    Real Estate Vs. Stocks: Which One's Right For You?

    There are ups and downs for both real estate and stock investments, so before diving in, know the differences between the two.
RELATED TERMS
  1. Capital Investment Analysis

    Capital investment analysis is a budgeting procedure that companies ...
  2. Terminal Value - TV

    The value of a bond at maturity, or of an asset at a specified, ...
  3. List Price

    The list price, in the real estate world, is the suggested gross ...
  4. Investment Real Estate

    Real estate that generates income or is otherwise intended for ...
  5. Earnings Announcement

    An earnings announcement is an official public statement of a ...
  6. Property Derivative

    A property derivative is a financial product that derives value ...
Hot Definitions
  1. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  2. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  3. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  4. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  5. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
  6. Interest Coverage Ratio

    The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest ...
Trading Center