Discounted CashFlow(DCF) Method is widely used for income producing properties. Properties such as rental properties can use DCF method. DCF involves discounting all the future perceived value to the present. It can be used to calculate your Internal Rate of Return(IRR) or calculating your Net Present Value(NPV). This method needs to have a specific holding period where you would sell off the investment. Any specific holding period is applicable but usually, we would take a 5 year holding period. DCF method requires you to determine the cashflows periodically, for example, every year, what cash cost did the investor bear?
Discounted CashFlow(DCF) Analysis
This is the formula that we want to use for calculating DCF. We will be finding either the “NPV” portion or the “r” portion of the formula. -Co is negative as this is the initial investment and it is coming out of your pocket, so it is a minus to your cash. A financial calculator can help as well to ease calculation. The formula is more for understanding.
What Are CashFlows(CF)?
CF are as per the word, cashflows per year. It must be cash, anything not cash like loan should not be included. This cash is the cash coming out from your pocket or going into your pocket pertaining to the investment. It must be solely for the investment, any cash not related to the investment should not be included. Every year you sum up your CF to find out your yearly CF.
Many are confused about Year 0 CF. Year 0 is actually not a year, it is a time where the investment is made. For easy calculation we always take it to be the very start of the year, for example, 12 am of 1st January 2018. Although, you can start your investment at any time of the year. Year 0 is not throughout the year but for the day the investment takes place. Therefore, any cash outflow or inflow should be included in year 0. For example, initial investment cost, closing fees, legal fees, etc.
The rest of CF from year 1, 2, 3… is CF throughout the whole year. Any cash inflow or outflow throughout the whole year should be recorded such as maintenance fees, vacancies, etc.
- Gross leasable area (GLA) = 91,000 sq ft
- Asking price = $8.5 million
- Current market rent = $15/sq ft
- Projected increase in market rent = 2% p.a.
- Vacancy allowance = 5% of PGI
- Operating Expenses = 30% of EGI
- The building can be sold in 5 years’ time for $9.7 million
- The required rate of return (discount rate) is 15%
Calculating CF from year 1 to 5, Potential Gross Income(PGI), Estimated Gross Income(EGI), Net Operating Income(NOI)
Listing out CF for NPV or IRR calculations. Sum of the final CF for individual Years.
As you can see in Year 5, it should be the total CF from start of Year 5 to the end of Year 5. Thus, it should include both the NOI and the final selling price. We will use IRR and NPV to determine if the investment is a good investment.
Net Present Value(NPV)
NPV is the net value after discounting all the future CF to the present. The formula is actually = initial investment + future investment returns. The initial investment is the amount of cash you come up with for the investment, it should be a negative CF. The future investment returns when discounting back to the present optimally should be positive if not there is no incentive to invest at all if ultimately you will lose money.
Investors will only close a deal if the PV(future investment returns) of an investment is ≥ purchase price. The outcome you want is for NPV to be ≥ 0, then the investment is worthwhile and has investment value. If the NPV is ≥ 0, such investment generates enough returns to cover any operating cost and at the same time earn the rate of return that you are expecting.
As mentioned the formula of NPV is = initial investment + future investment returns. If the future investment returns being discounted to the present can cover your initial investment cost this means that you are making an investment that is worthwhile. The future values discounted based on your discount rate that has a positive NPV gives you a return that is more than what you expected.
From the formula, we will need to input a discount rate to calculate our NPV. This discount rate is the rate of return that an investor would expect to get from his investment. Thus, if a discount rate of 15% is used and the NPV is 0 it means that the investment is giving the investor a 15% return. If the NPV is > 0, the investment is giving the investor more than 15% rate of return. If NPV < 0, the investment is giving the investor less than the required 15% rate of return and the investment should not take place.
A more complicated rate of return:
Total required return = risk-free rate + property risk + country risk + currency risk + diversification + liquidity risk
Using A Financial Calculator For DCF
It would be taxing to use the formula to calculate the NPV, thus, a financial calculator can come in handy. I am using BAII Plus thus my explanation will be suited for BAII Plus calculator. The methodology is similar with other calculators, the difference could only be with the buttons. Thus, learning the concept is more important.
As seen from the above example, the cashflow are all calculated. Using the calculator click CF.
- CFo is CF for Year 0. Key in Year 0 CF of -$8,500,000. Press “↓”.
- C01 is CF for Year 1. Key in Year 1 CF of $907,725. Press “ENTER” and press “↓”.
- F01 is how many periods did the CF occur. In this case, it is once for year 1. Key in 1. Press “ENTER” and press “↓”.
- Repeat steps 2 and 3 up till CO5 and F05.
- Press “NPV”. “I =” will pop up. This is the discount rate that you need to put in. From our example the discount rate is 15%. Key in 15. Press “ENTER” and press “↓”.
- “NPV =” will pop up, press “CPT”
- NPV = -$527,742.53
Calculating Purchasing Price With NPV
If your NPV is ≥ 0, you can go ahead with the purchase price as the investment is going to give you your required rate of return. However, what if the NPV calculated is < 0? How much lower should the purchase price be to allow an investor to make his required return? As mentioned earlier, the formula is actually initial investment + future investment returns. This means that if NPV is < 0 you will either have to decrease the initial investment or increase future investment returns. It is often hard to increase future investment returns as future returns need to be reflective of the expected future CF. Thus, we want to decrease the initial investment, but by how much? It is actually, just the negative number of the NPV. If your NPV is -$60,000 you will need to reduce the purchase price by -$60,000 or more, such that the present value will be ≥ 0.
Internal Rate of Return(IRR)
The IRR shows the rate of return on the investment. This is the rate of return where NPV = 0. The outcome you want is for the IRR to be higher than your required rate of return. Very logically, you want your investment returns(IRR) to be more than your expected rate of return.
Using a financial calculator, repeat steps 1 to 4, then click on “IRR” and press “CPT”. You need to note that if your CF is monthly you will need to multiply by 12 to get the annual IRR. In this example, the CF is yearly thus no need to multiply by 12. The IRR would be 13.23%.
If you noticed the NPV is negative because the IRR is 13.23% which is less than our expected rate of return of 15%, thus, it is not a good investment. If you want to continue with the investment, the purchase price can be lowered by the amount of NPV as mentioned before at previous section. When we discount future CF to the present, it is based on our best assumptions about future market rents, vacancy, operation cost, etc. Those assessments are based on past, current and future market conditions. Thus, it is subjective and relies greatly on experience to generate an accurate value. It is hard to predict the future, but based on concrete data and information, we can come up with a scenario analysis to have a rough gauge if the investment is worthwhile.
Discounted Cash Flow Method Quiz
Start this quiz whenever you are confident!What is the main thing you need to determine when doing DCF analysis?Discount rate
Quality of Property
Wrong!Should you include your initial capital investment?Yes
Wrong!What does NPV value means?The value of my investment if I discount all my future cashflows back to the present with my discount rate.
My final selling price, discounted back to today.
The amount I need to buy a property.
It does not show anything, but it should be a negative number.
Wrong!What value could NPV be for a good investment?-1,000,000
Wrong!If IRR is 8% and your expected rate of return(discount rate) is 10%. Would NPV be positive or negative?Positive
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