NPV Discount Rate

[Anonymous]

Hi Michael

Thanks for the lesson on DCF.
I wanted some understanding about the following:

In my organisation we currently do not do any Discounting for future cashflows. We are a Real estate fund with project spanning for 3-7 years of development and post that 1 year to fund closure.

We just calculate cashflows and calculate IRR on the cashflows stream. I always felt this was not the true representation of the correct returns due to Time Value of Money. Can you please explain if this is the case?
Also there was always a dilemma regarding the Discount rate to be used.

Usually at our fund level the investor need 15% preferred return so would you suggest the Discount rate to be 15% + Risk factor associated with the project ? if now what other approach could be taken to decide the DCF discount factor.

Thanks
Pratik

[Spencer Burton]

Hi Pratik,

Spencer here. I’ll let Michael respond as well, but let me offer my two cents.

In my experience development firms do not generally use PV (or NPV) calculations. That’s because the PV calculation is really asking, to achieve an X return (the IRR or discount rate) what do I have to pay today? From a DCF perspective, that involves one big negative cash flow in time zero followed by a string of positive cash flows until the end of the analysis period. The cash flows in an opportunistic investment like development do not model out in that fashion.

I see PV used most often by asset management teams and core investors. They have well-established internal target return assumptions, and will use that target return as a discount rate to understand the value of the investment.

But how do they arrive at that target return assumption (i.e. discount rate)? You have part of the equation, the cost of your equity capital. But if you plan to add leverage, you must also take into account the cost of debt capital. So if you raise equity at a 15% pref and borrow at 6%, your discount rate will be some blend of the two rates plus what you as a sponsor need to earn.

In practice though, there’s no formula that real estate firms use (no, not even WACC). In the real world, it’s much less of a perfect science. Each firm will have their own required/target return depending on the risk profile of the investment, and that will become their discount rate when performing this type of analysis.

Spencer

[Anonymous]

Thanks for your reply Spencer.

Agreed in an opportunistic deals the cashflows will not model out. But as we are a real estate fund we have set preferred return thresholds below with we would not considering any investment as we have agreed preferred returns commitment to our fund investors.

Also looking it from the development perspective our organisation adopts development + hold strategy ( Core + Plus Combined with Value addition). As we are evaluating opportunities that can go up to 10 years post development ( Private Rented Sector or Build to Rent Model).

In that case does it still not make a case to use DCF to come to the land price that we can afford to pay for?
Considering we are projecting cashflows upto 17 years ( 5-7 years development + 10 year operations) does the future cashflow numbers post 5 years represent a realistic perspective?

Pratik

[Spencer Burton]

Some great points Pratik. Allow me to clarify. It is definitely worthwhile for an opportunistic investor to use DCF analysis. My point was, calculating the present value is not possible due to the string of investment cash flows that go out beyond time zero. But the DCF is extremely valuable for calculating IRR, equity multiple, estimating breakeven and stabilization, and host of other risk and return metrics that rely on a projected period of cash flows (we go much deeper into this in courses 3 and 3a).

And thank you for bringing up residual land value calculation! For those who are unfamiliar with the analysis, Residual Land Value Analysis is a method for calculating the value of development land. The most common method is to subtract from the total value of a development, all costs associated with the development, including profit but excluding the cost of the land. The amount left over is the residual land value, or the amount the developer is able to pay for the land given the assumed value of the development, the assumed project costs, and the developer’s desired profit.

What I just described does not require building out a full DCF. However, a more robust way to calculate residual land value is using a DCF. If you’d like to see this in action, I included a residual land value analysis module in my All-in-One that does just this (see below).

How it works is you solve for some target return metric. It may be IRR, Equity Multiple, Net Profit. You could even solve for a risk metric, such as stabilized loan proceeds if your goal was to cash-out refinance at stabilization. And while this isn’t a PV calculation, this particular residual land value analysis method uses the DCF to help you arrive at an appropriate price to pay for the land.

We will not be covering residual land value in the Accelerator, but here are a few resources you can look at:

1) How to calculate residual land value

2) Using the Residual Land Value Module in the All-in-One

As always, thanks for the great question!

Spencer

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