Discounted Cash Flow

An investment analysis tool used regularly by real estate professionals to make buy, sell, hold, and development investment decisions. The discounted cash flow (DCF) is a process by which the real estate professional forecasts the future cash flows of an investment (rents, expenses, CapEx, debt service, sale price, etc), and then discounts those cash flows to present to arrive at time value of money return metrics such as internal rate of return and net present value.

The estimated cash flows from the DCF can also be used to calculate other risk and return metrics such as debt service coverage ratio, breakeven occupancy, debt yield, cash-on-cash return, equity multiple, etc, as well as perform other analysis such as sensitivity analysis.

The most common non-Excel DCF software used in real estate is created by the Altus Group and is called ARGUS. An example of a DCF in Microsoft Excel is the A.CRE All-in-One Underwriting Model for Real Estate Acquisitions and Development.

Putting ‘Discounted Cash Flow’ in Context

Emily Johnson, a junior at the University of Arizona majoring in finance, was recently given a real estate finance assignment that required her to build a Discounted Cash Flow (DCF) model. As part of the project, Emily needed to evaluate a core multifamily property acquisition using DCF analysis to determine whether the property was a sound investment. Fortunately, Emily had recently completed the A.CRE Accelerator program, where she learned how to build robust DCF models in Excel, giving her the confidence to approach the assignment.

The Property: Desert Vista Apartments

For her assignment, Emily was tasked with analyzing Desert Vista Apartments, a 100-unit, market-rate multifamily property in Phoenix, Arizona. The property was fully stabilized, with a steady stream of rental income and minimal need for significant capital expenditures, making it an ideal example of a core real estate investment.

Emily’s Objective

The goal of Emily’s assignment was to project the cash flows for Desert Vista Apartments over a 10-year holding period, estimate a sale price at the end of the period, and use a DCF analysis to calculate key investment metrics such as the Internal Rate of Return (IRR) and Equity Multiple to determine if the investment met her investor’s criteria.

Building the DCF Model

Using the skills she learned in the A.CRE Accelerator program, Emily began by forecasting the future cash flows of the property:

• Effective Gross Income (EGI): Instead of simply using rental income, Emily accounted for both the rental income and other sources of income, such as laundry and parking fees, while adjusting for factors like vacancy and concessions. She projected an initial EGI of $1,150,000 for Year 1 with a 2% annual growth rate.
• Operating Expenses: Desert Vista had stable operating expenses, estimated at $450,000 in Year 1, which Emily increased by 2% annually to account for inflation.
• Net Operating Income (NOI): Emily calculated the property’s NOI by subtracting operating expenses from EGI. For example, in Year 1, the NOI was $700,000.
• Capital Expenditures (CapEx): As a core investment, CapEx was relatively minimal. Emily estimated a reserve of $300 per unit annually, or $30,000 in total, to account for ongoing maintenance.
• Debt Service: For the purposes of this assignment, Emily assumed no debt, simplifying her cash flow projections to focus entirely on the property’s performance without leverage.
• Purchase Price: The investor was willing to purchase Desert Vista Apartments based on the Year 1 NOI and a 5.5% capitalization rate. Emily calculated the purchase price as:

Purchase Price = Year 1 NOI / Cap Rate = 700,000 / 0.055 = 12,727,273

• Sale Price: The investor planned to exit the investment at the end of Year 10. To estimate the sale price, Emily applied a 5.5% exit cap rate to the projected Year 11 (F12) NOI, as the final year’s stabilized NOI is often used to estimate reversion value. With a Year 11 NOI of $853,300, the estimated sale price was calculated as:

Sale Price = Year 11 NOI / Exit Cap Rate = 853,300 / 0.055 = 15,514,545

Solving for Investment Metrics

Emily’s analysis focused on determining whether the investment met the return thresholds her investor was targeting. To do so, she solved for two key metrics:

• Internal Rate of Return (IRR): After projecting the property’s annual cash flows over the 10-year holding period and factoring in the sale proceeds in Year 10, Emily used Excel’s IRR function to calculate the IRR. The IRR turned out to be 8.6%, exceeding the investor’s required rate of return of 8%.
• Equity Multiple: Emily then calculated the equity multiple to understand the total return on equity over the 10-year period. She did this by dividing the total cash distributions (cash flow plus sale proceeds) by the total equity invested. For Desert Vista, with total cash distributions of $22,842,205 and an initial equity investment of $12,727,273, the equity multiple was calculated as:

Equity Multiple = Total Cash Distributions / Total Equity Invested = 22,842,205 / 12,727,273 = 1.79x

Conclusion

With an IRR of 8.6% and an equity multiple of 1.79x, Emily determined that Desert Vista Apartments was a solid investment opportunity based on her investor’s return criteria. Her analysis demonstrated how the Discounted Cash Flow method, when combined with key metrics like IRR and equity multiple, is an essential tool for evaluating the long-term profitability of real estate investments.

Thanks to the skills she gained from the A.CRE Accelerator program, Emily was able to confidently model future cash flows, project a sale price, and determine the investment’s overall viability—all crucial components of real estate investment analysis.

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Frequently Asked Questions about Discounted Cash Flow (DCF)

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