The Discounted Cash Flow (DCF) Model
The Discounted Cash Flow (DCF) model is a mathematical model that is used widely in investment analysis in real estate investment analysis and specifically for the estimation of the Present Value (PV) or Net Present Value (NPV) of cash flows associated with an investment over the investment holding period.
The DCF model consists of a series of periodic cash flows, which are discounted to the present time (time 0) using a discount rate.
The present value model estimates the present value of anticipated cash flows from the investment without taking into account the initial cash outlay or investment cost at time 0. In the net present value model, however, the initial cash outlay in time zero is taken into account. Thus, the two important things that determine the net present value of an investment in the discounted cash flow model are the series of cash flows used and the discount rate. The discount rate can be defined as the required rate of return by the investor and its level depends on a number of factors that are discussed in another article posted in this site. The important things to have in mind about the discounted cash flow model are:
1) All periodic cash flows that are used in the discounted cash flow model have to refer to periods of the same length (annual, semi-annual, quarterly, monthly)
1) All cash flows that are used in the discounted cash flow model refer to the future. For this reason analysts need to use projected rental income, operating expenses, cap rates, values, etc. Forecasts of rental rates for different property types are provided by various vendors at the market level. These forecasts need to be adjusted to take into account the position of the building under consideration vis a vis the market average.
3) The discount rate used must represent the discount rate that corresponds to the length of period in which the cash flows refer to. For example, if quarterly cash flows are used then a quarterly discount rate needs to be used.
The formula for the discounted cash flow model for the calculation of NPV, which takes into account investment cots (cash outlays) at time 0, is the following:
NPV = CF0 + CF1/(1+d) + CF2/(1+d)2 + ……..CFn/(1+d)n
Where CF represents the cash flow of each period within the investment analysis horizon, d the discount rate and n the last period of the investment horizon. As indicated earlier, the first cash flow CF0 represents the initial cash outlay or investment cost. The last cash flow CFn includes any income expected to be received during the last period of the investment horizon plus the market value or sales price of the property at that point in time.
Very important to have in mind that the d is the periodic discount rate that corresponds to the length of period that cash flows refer to.
For example, if cash flows are quarterly then the quarterly discount rate needs to be entered in the formula. Caution is needed here because discount rates are usually quoted in annual terms, and one might be tricked to use an annual discount rate with quarterly cash flows, in which case a very incorrect result will be obtained. Furthermore, caution is needed when deriving quarterly or other periodic discount rates from annual discount rates to take into account the compounding effect. The correct formula for deriving the quarterly discount rate (dq) from the annual discount rate (da) is:
dq = (1+ da)1/4-1
The correct formulas for deriving the monthly discount rate (dm) and the semiannual discount rate (ds) from the annual discount rate (da) are:
dm = (1+ da)1/12-1
ds = (1+ da)1/2-1
Use of the DCF Model in Real Estate
The discounted cash flow model is widely used in real estate especially for the calculation of NPV or the internal rate of return (IRR). The internal rate of return of an investment is actually the discount rate that renders the NPV of the expected cash flows equal to 0. Typically the following things apply when using the DCF model for the evaluation of real estate investments:
1.Use of after-tax cash flows
2.Cash flow at time 0 is negative as it represents investment costs (property acquisition costs, plus any pre-acquisition costs for due diligence, such as market studies, feasibility studies, legal, environmental studies, etc., or other expenses). Subsequent cash flows might be negative as well, especially in the case of real estate development projects
3.Cash flows represent the sum of all anticipated revenues and costs in each period; notice that such costs and revenues will differ by property type and for each property depending on its idiosyncrasies. Special attention is needed when projecting property income and expenses in order to estimate these cash flows. Reliable projections of a property's net operating income (NOI) need to take into account the property’s lease rollover schedule, expiring leases and vacancy durations, as well as potential changes in current market rents, which will affect income from new leases. Projecting market rents is not an easy task. Most reliable projections of market rents can be derived through advanced econometric models that take into account most likely changes in demand, supply and the way these changes affect rent adjustments. There are a number of vendors specialized in real estate forecasting that provide rent forecasts for the largest metropolitan areas in the country and the major property types, such as office, retail, industrial and apartments.
When is the DCF Model Used
The discounted cash flow model is used in the following cases:
1) When the investor wants to estimate what is the maximum price he must pay to achieve a minimum or required rate of return. This price can be estimated by discounting the cash flows expected from the property over the holding period using as discount rate the investor’s required or minimum rate of return. This is a present value, not a net present value, calculation since the initial cash outlay is not known and is to be determined.
2) When the investor wants to evaluate the return that a property investment will provide over the investment horizon if it is acquired at a given price. This is calculated by including the acquisition price in the cash flows to be discounted, and estimating the discount rate that sets the NPV equal to zero. The so estimated discount rate is actually the internal rate of return (annual, monthly, quarterly, etc.) depending on the length of the period to which the cash flows refer to.
The DCF Model and Borrowing
The discounted cash flow model is the same whether borrowed money are used to finance part of the property acquisition or not. What it does change is how the cash flows used in the DCF formula are calculated. In particular, if the analyst wants to take into account the effect of borrowing on the project’s NPV or IRR the loan payments over the holding period need to be appropriately and fully incorporated in the project’s after-tax cash flows. In particular, this would include replacing any capital costs that are financed through borrowed money, with the respective periodic loan payments. For example, if construction costs of $20 million are financed by 50%, then the negative cash flow of $20 million will be replaced by a negative cash flow of $10 million (50% of $20 million) and a negative cash flow equal to the payment for a loan of $10 million (plus any other incurred costs in association with obtaining the loan, such as bank fees, etc.).
Notice that in the case of construction loans, banks will allow interest only payments during the construction period with principal payments starting after project completion. Also in incorporating the effect of borrowing in the discounted cash flow model, the remaining loan balance needs to be subtracted from the last cash flow, which should also incorporate a positive cash flow representing the property’s anticipated market value or resale price. The return that incorporates the effect of borrowing is referred to a leveraged return. This represents a typical use of the DCF model since borrowing is commonly used in real estate investing due to the large capital requirements.
Related Posts
Leveraged IRR Calculation
Investment Value
Net Operating Income
Capitalization Rates
Return from the Discounted Cash Flow Model to Investment Analysis
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