How to Use Discounted Cash Flow Analysis in Commercial Real Estate
Discounted Cash Flow Analysis (“DCF”) is the foundation for valuing all financial assets, including commercial real estate. The basic concept is simple: the value of a dollar today is worth more than a dollar in the future. The value of an asset is simply the sum of all future cash flows that are discounted for risk.
The timing of the future cash flows and the likelihood they will occur greatly influences the price an investor would be willing to pay for an asset today. Riskier cash flow streams are discounted at higher rates, while more certain cash flows are discounted at lower rates. If an income stream has a 100% chance of occurring (such as in the case of coupons on government bonds), then the return an investor will require is far less than the return required for an income stream that has a 50% chance of coming to fruition.
Prospective real estate investors tend to be familiar with, and rely on, capitalization rates as a short cut method to value real estate assets; however, this method has inherent limitations. DCF is a more comprehensive and accurate way to value an asset.
For the purposes of this article, we are only focusing on valuing real estate without leverage. When comparing one investment to another, it’s best to evaluate them on an unlevered basis because leverage creates unnecessary noise when trying to determine how much an asset is actually worth based on the respective risk factors. A common mistake made by many investors is solving for a leveraged return, while ignoring the other risk components. An investment generating a 15% annualized return using 60% leverage actually produces a better risk-adjusted return than one generating 20% using 90% leverage, all other things being equal. Using financial leverage responsibly will enhance the return on equity, but it doesn’t change the asset’s inherent value.
Here’s the basic formula for DCF. We’ll expand on this formula throughout the article.
|+ … +|
CF = Cash Flow
r = Discount Rate (WACC)
To arrive at a property’s value, we need to forecast all of the property’s future cash flows and calculate what they are worth today. For example, if we wanted to know the value of a cash flow stream of $100 that extends for 3 years discounted at 8%, the formula would be as follows:
|Present Value of Year 1 Cash Flow:|
|Present Value of Year 2 Cash Flow:|
|Present Value of Year 3 Cash Flow:|
|Present Value of All Cash Flows:|
What this means is that at a price of $257.71, the investor will earn an 8% return on this cash flow stream.
The discount rate is simply the required return one would need to achieve for the level of risk assumed. The important thing to understand is that lower discount rates are applied to investments with lower risk characteristics and higher discount rates are applied to projects that exhibit higher risk characteristics.
While this looks complicated, Excel actually makes it very simple. Investors can simply plug in the cash flows and use the ‘=NPV’ formula to arrive at the net present value of any annual cash flow stream.
How is a Property’s Cash Flow Determined?
A property’s cash flow is determined by incorporating both annual cash flow and sales proceeds, also known as terminal or residual value. The residual value is calculated by taking the net operating income in the year following the forecast hold period and dividing it by the future capitalization rate. Again, the capitalization rate doesn’t tell the entire story, so we balance this against a host of other variables. We evaluate our residual value against replacement cost (the cost to build a similar property today), the next buyer’s IRR, and other comparable sales to determine the appropriate sales price at the end of our hold period.
What is the Appropriate Discount Rate?
As we have already discussed, future cash flow forecasts contain many different variables and they become less accurate with time. The variability of these cash flows will largely determine the appropriate discount rate. The rate at which future cash flows will be discounted is determined by both the risk of the asset and the risk of the business plan. To provide some context, unleveraged discount rates in real estate fall between 6% and 12%.
Think of the discount rate as the expected rate of return, or IRR before using leverage, an investor would expect to receive. Asset risk refers to the type of real estate. Hotels, for example, tend to have more asset-level risk than apartments due to higher operating leverage and shorter duration of leases (nightly versus annual leases for apartments). Business plan risk refers to the investment strategy behind the project. Is the investment a ground-up development that requires substantial planning, effort and cost to achieve the end result or is it more of a passive investment in a project with a credit tenant who has a decade or more left on their lease? The less business and asset level risk, the lower the discount rate, or required return, will be.
In the example below, we analyze the cash flows generated from a stabilized apartment building and compare against those generated by a hotel. Each asset is expected to produce $100 of cash annually and a residual value is calculated using the assumption that the capitalization rate upon sale in the future is equal to the discount rate being used. In a world where no growth occurs, the discount rate and the capitalization rate are largely one and the same.
Apartment Annual Cash Flows
Hotel Annual Cash Flows
When the NPV formula is applied to the respective cash flows using the discount rates reflected, there is a substantial difference in value between the two assets. While both assets are expected to produce $100 per year in cash flow, there is the potential for greater variance around the hotel’s cash flow, resulting in the application of a higher discount rate. The hotel investor would be willing to pay no more than $892.50 for this cash flow stream, while the apartment buyer would be willing to pay as much as $1,333. The apartment investor would expect to generate a 7.5% unlevered return, while the hotel investor would expect to generate an 11.0% annual return.
Business plan risk also influences discount rates. A ground up construction project is generally riskier than an existing asset that requires a value-add renovation. This chart shows how business plan risk on the same asset impacts valuation:
The ground-up development has the potential to generate higher cash flow than the other opportunities upon completion and lease-up of the project. This is because the ground-up development will likely have a more modern design, physical attributes, and amenities relative to the stabilized and value-add properties.
Every cash flow in a DCF forecast is based on the probability of occurrence. In reality, these outcomes can be vastly different than what was originally projected. In some cases, actual investment results will far exceed expectations and in other cases, they will underperform. If we flip a coin, the probability of landing on heads is 50%. However, the outcome of flipping a single coin multiple times could have a 0% or 100% likelihood of landing on heads. Probability intersects with reality the more times the coin is flipped. While real estate investing is not coin flipping, the law of large numbers still prevails. This is the basis for why Origin believes real estate funds are the smartest vehicle for individual investors: our fund investors are diversified across 15-20 properties so the variance of one individual property has a small impact on the overall portfolio.
Forecasting is an inexact science and hundreds of variables go into creating financial models. DCF analysis is the most comprehensive method utilized to evaluate all of the risk factors that are considered in a real estate investment. As a fund manager, we understand the nuances of the inputs and market variables better than most. Origin collects, reviews and analyzes data for every assumption that goes into our DCF analysis and spends a substantial amount of time evaluating how this data translates into value for an investment opportunity. These efforts have culminated in our ability to achieve a 24% net IRR across our first two funds and will allow us to maintain a tight standard deviation of returns in periods of increased market volatility.