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 industries tend to use discounted cash flow (DCF), and why?

    Understand the valuation method of discounted cash flow analysis and why it is more suitable for evaluating certain industries ... Read Answer >>
  2. How Do I Use Discounted Cash Flow (DCF) Analysis?

    Understand the meaning and significance of discounted cash flow (DCF) to stock market analysts. Read Answer >>
  3. How is perpetuity used in determining the intrinsic value of a stock?

    Learn about the basics of a perpetuity, its valuation, how it is calculated and how it is used when evaluating the intrinsic ... Read Answer >>
  4. What are the disadvantages of using net present value as an investment criterion?

    While net present value (NPV) calculations are useful when you are valuing investment opportunities, the process is by no ... Read Answer >>
  5. What is the importance of the capitalization rate in real estate investing?

    Find out why an investment property's capitalization rate is important to real estate investors and how it can be used to ... Read Answer >>
Related Articles
  1. Investing

    Top 3 Pitfalls Of Discounted Cash Flow Analysis

    The DCF method can be difficult to apply to real-life valuations. Find out where it comes up short.
  2. 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.
  3. Small Business

    Calculating Net Present Value at Different Points Using Excel

    Calculating the net present value (NPV) of your investment projects using Excel.
  4. Financial Advisor

    A Guide on the Risk-Adjusted Discount Rate

    When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the risk-adjusted discount rate.
  5. Investing

    Taking Stock Of Discounted Cash Flow

    Learn how and why investors are using cash flow-based analysis to make judgments about company performance.
  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 to flip a property or hold it. Find out which strategy may best for you.
  8. Investing

    7 Steps to A Hot Commercial Real Estate Deal

    For savvy real estate investors, times of lower prices reveal investment opportunity.
  9. 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. Discounted Cash Flow (DCF)

    Discounted cash flow (DCF) is a valuation method used to estimate ...
  2. Initial Cash Flow

    Initial cash flow is the amount of money paid out or received ...
  3. Discounting

    Discounting is the process of determining the present value of ...
  4. Terminal Value - TV

    The value of a bond at maturity, or of an asset at a specified, ...
  5. Profitability Index

    An index that attempts to identify the relationship between the ...
  6. Rate of Return

    A rate of return is the gain or loss on an investment over a ...
Hot Definitions
  1. Risk Tolerance

    The degree of variability in investment returns that an individual is willing to withstand. Risk tolerance is an important ...
  2. Donchian Channels

    A moving average indicator developed by Richard Donchian. It plots the highest high and lowest low over the last period time ...
  3. Consumer Price Index - CPI

    A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, ...
  4. Moving Average - MA

    A moving average (MA) is a widely used indicator in technical analysis that helps smooth out price action by filtering out ...
  5. Stop Order

    A stop order is an order to buy or sell a security when its price increases past a particular point in order to limit losses ...
  6. Inflation

    The rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of ...
Trading Center