Though discounted cash flow formula is popular and widely used, there are lots of misconceptions about it. In this topic, DC Fawcett intends to clear some of the misunderstandings about this concept and educates the people with some of the facts.
Discounted cash flow formula for real estate
To understand the discounted cash flow concept, you need to know the basic real estate cash flow. You need to analyze some of the factors before you go for it. These factors are
- How much amount goes for the investment?
- When does the amount go into the investment?
- How much amount we get in this investment and
- When do we get that amount?
To answer these questions, you need to do more analysis so you can arrive at the right figures. They are
- Holding period –
is generally assumed as the timing of cash flows occurred at the end of the year. In commercial real estate, the holding period has a standard variation from 5 to 15 years for the financial analysis.
- Initial investment –
is normally shown as nil but it includes the acquisition costs required to buy an asset, deducting the mortgage proceeds if any. It can also be called as total cash out of hand required to buy the property.
- Annual Cash flow –
Is taken as annual cash flows before tax for a real estate property. In other words, it is gross profit minus all the expenses and debt service. Negative cash flow means the money is going on investment. Positive cash flow means the amount is coming out of the investment.
- Sale Proceeds –
represents the cash flow received after the property disposition. It shows the last period of the holding period in real estate cash flow.
What is discounted cash flow analysis?
Discounted cash flow analysis is a technique that is used in finance and real estate to discount the future cash flows to the present. Following are the steps for real estate valuation.
- Visualize the cash flows that occur in future.
- Establish the total return that is required.
- Discount the cash flows to the present at the required rate of return.
Forecasting the expected future cash flows enables you to create its projection, known as real estate proforma. It puts all the elements in place which gives you the answer to the 4 basic questions of the real estate cash flow model, mentioned above. The investors will get the information about their total return for the project. In the case of an individual investor, it is the rate of return they want. The requited return for a corporate investor is the weighted average cost of capital (WACC). Ascertaining the discounted rate has always been a discounted cash flow. It includes accounting for the risks taken for the project compared to other alternative investment opportunities.
DC Fawcett says that Once you forecast the cash flows and establish a discount rate, the discounted cash flow analysis for the real estate project can be used to derive the internal rate of return and net present value.