Investment value, in the case of real estate, is the present value of a property to an investor, given his/her return requirements (which depends on prevailing market returns and the investor's
sensitivities) and the expected income stream from the property over the investor's holding period. An investor considering a property for acquisition can use different measures to assess its value from an investment point of view.
The DCF model can be used to estimate the Present Value (PV) of the income stream expected to be received from the property over the investor's holding period using as
discount rate the investor’s required annual rate of return. The estimated present value represents the value of the property to the particular investor at the time of analysis, in the sense that this is the value the investor would be willing to pay to acquire the property in order to achieve his/her required rate of return. In this case the discounted cash flow analysis should ignore investment costs.
How to Use Investment Value
The real estate investment decision rule is the following:
If IV ≥ IC ====> Invest
If IV < IC ====> Do not Invest
where IV = Investment Value
IC = Investment Cost
The investment cost includes property purchase costs and other acquisition or pre-acquisition costs, such as notary fees, legal expenses, and other expenses associated with all due diligence that needs to be carried out before finalizing the transaction.
Project IRR versus Investor Required IRR
In estimating the present value of a property using the
DCF model, the investor needs to take also into account the expected
market value of the property at the last year of the holding period, in order to incorporate in the calculation any anticipated capital gains or losses. This reversion or resale value is usually estimated by dividing the expected
net operating income (NOI) of the property during the last year of the holding period by the
capitalization rate expected to prevail in the market during that year.
The DCF model can also be used to evaluate another important evaluation measure,
the internal rate of return (IRR). This is the annual rate of return expected to be received by the investor if the property is bough at a given price. Thus, instead of calculating what the value of the property is for the investor given his/her return requirements, one can calculate the rate of return a property can provide, if bought at the seller’s asking price or some other price. Then the investor can compare the achievable rate of return under different acquisition price scenarios and compare it to the required rate of return. Obviously, if an achievable rate of return is greater than the investor’s required rate of return, it means that the seller’s asking price is lower than the investment value of the property for the investor.
Return from Investment Value to Property Investing
