An analysis using discounted cash flow (DCF) is a measure that's very commonly used in the evaluation of real estate investments. Admittedly, determining the discount rate—a crucial part of the DCF analysis—involves a number of variables that may be difficult to predict accurately. Despite the difficulties, DCF remains the one of the best tools for setting a value on real property investments, such as real estate investment trusts (REITs).
- Discounted cash flow (DCF), a valuation method used to estimate the value of an investment based on its future cash flows, is often used in evaluating real estate investments.
- Initial cost, annual cost, estimated income, and holding period of a property are some of the variables used in a DCF analysis.
- Though the discount rate of real estate can be tough to determine, DCF remains one of the best tools for evaluating real estate investments.
What Is Discounted Cash Flow?
Discounted cash flow analysis is a valuation method that seeks to determine the profitability, or even the mere viability, of an investment by examining its projected future income or projected 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.
In other words, DCF analysis attempts to figure out the value of a company or an asset today, based on projections of how much money it will generate in the future. A discount rate is used to derive the NPV of the expected future cash flows. For the evaluation of real estate investments, the discount rate is commonly the real estate's desired or expected annual rate of return. Depending how far into the future you go, the formula for DCF is:
The ultimate purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money.
Calculating Discounted Cash Flow for Real Estate
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.
Example of Using DCF in Real Estate Investments
An investor could set their DCF discount rate equal to the return they expect from an alternative investment of similar risk. For example, let's say you could invest $500,000 in a new home that you expect to be able to sell in a decade for $750,000. Alternatively, you could invest her $500,000 in a real estate investment trust (REIT) that is expected to return 10% per year for the next 10 years.
To keep things simple, let's assume you're not including the substitution costs of rent or tax effects between the two investments; we'll stick with a single cash flow—the price of the home in 10 years. So, all you need for the DCF analysis is the discount rate (10%) and the future cash flow ($750,000) from the future sale of the home.
In this example, DCF analysis shows that the house's future cash flows are only worth $289,157.47 today. So you shouldn't invest in it; the REIT, which will return $500,000 in the next decade, offers better value. Once tax effects, rent, and other factors are included, you may find that the DCF is a little closer to the current value of the home.