Discounted cash flow analysis, or DCF, is very commonly used in the 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 the evaluation of real estate investments, the discount rate is commonly the desired or expected annual rate of return.
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.