When it comes to evaluating real estate investments, there are a number of methods you can use. Discounted cash flow analysis is one of these methods and perhaps the most widely used way for valuation of all financial assets, including residential and commercial properties. It is based on the time value of money which says that a dollar today is worth more than what it would be in the future. The value of an asset is determined by all future cash flows discounted for risk.
The willingness of an investor to pay for an asset depends on the timing of the future cash flows and its likelihood. If the investment is riskier, the cash flow stream will be discounted at higher rates. For assets with more stable stream of cash flow, the discounted rates are low. If an investment has a 100% chance of generating an income stream, then the return required by the investor will be less than an investment which has say, a 50% chance of generating an income. A good example of such stable assets is coupons or government bonds.
Some real estate investors use cap rates to determine the value of their real estate property. This method, although easier to calculate, is not always the right approach to value an asset. DCF is a lot more extensive and has much less limitations as compared to the cap rate method.
In this article, we will only focus on real estate where leverage is not involved as it makes the work much more complicated and can cause a hindrance in determining the actual value of the asset. Risk factors should ideally be accounted for to determine the appropriate value.
Let’s delve deeper into the topic by starting off with the basic formula used to calculate DCF:
To know the accurate valuation of the property, we will need to calculate the current worth of all future cash flows of the property. When the assumption of risk has been made, the required rate of return you’ll need for it will be your discount rate.
If an investment has lower risk attached to it, the discount rate will also be low. Similarly, if the investment has more risk associated, the discount rate will be higher as well.
Cash Flow Calculation of Properties
When it comes to calculating a property’s cash flow, both annual cash flow and residual value should be incorporated. The simplest way of determining the residual value is to divide NOI by the future cap rate.
We know that the cap rate is not an accurate measure of asset valuation hence residual value should be measured against other determinants such as replacement cost and the future buyer’s IRR.
Appropriate Discount Rate and its function
Cash flow forecasts take into consideration a number of factors and they become less accurate with the passage of time. The appropriate discount rate depends on cash flow variability and both the risk of an asset and the business plan determine the rate of future cash flows.
For better understanding consider a discount rate as the expected rate of return that an investor can expect to receive. Hotels are an example of real-estate assets that have a higher risk because of the duration of leases involved in its operations. Business plan risk, on the other hand, is based on the investment strategy being used to run the project. The investment may be a ground-up development that requires a substantial amount of upgrade to ensure it produces a sizable income stream or a passive property with a long-term tenant. If both types of risks are low, the required rate of return will also be low.
In ground-up development projects,there is a potential to generate higher cash flows as improvements are added. The ground-up development projects are also more contemporary and have attributes similar to stabilized and value add properties.
It is important to remember that the DCF forecast is based on probability. The actual outcome may or may not be the same. Sometimes, you will find that actual results are extremely different from what was predicted. This means that you can either experience under performance or high performance of the property.
Forecasting is based on intelligent guesswork and historical performance. It is not exactly accurate and a number of factors go into creating a financial model that can be used by investors. DCF analysis is a better measure of evaluation as all the risk factors that can occur in a real estate investment are taken into account.
Even though the forecast is based on probability, the law of large numbers applies to the way the property performs. This is why we believe that individual investors should opt for real estate funds. We provide you with a portfolio that is diversified across multiple properties so that fluctuation in an individual property will have little impact on your entire portfolio.