Discounted Cash Flow Analysis

General Real Estate Investing
1

This method is the most widely accepted financial method to approach value.

Purchase Price = $100,000
Closing costs = $3,000
Equity Investment = $20,000
NOI yr1 = 10,000 and escalated at $1,000 per year

yr 0 = $-23,000
yr 1 = $10,000
yr 2 = $11,000
yr 3 = $12,000
yr 4 = $13,000
yr 5 = $14,000+$33,373.51

Beginning Year 6 Reversion

Mortgage Balance = $73,819.15 @ end of 5 years
Selling Expenses = (3%*110,507.89) $3,315.23

  • Value = $110,507.89 (100,000*1.02^5 or 2% per year for 5 years)
    = Reversion Value = $33,373.51

The goal is to take all these cash flows and discount them to a present value.

Discount Rate = 8%

yr 0 = $-23,000
yr 1 = $10,000
yr 2 = $11,000
yr 3 = $12,000
yr 4 = $13,000
yr 5 = $14,000+$33,373.51

Net Preset Value = $47,012.98
Required Investment = $23,000.00
Cash On Cash = 15.3714%
Internal Rate of Return = 51.93%

The decision in this example is easy to see. It’s a good deal because the NPV is higher than the initial investment. This should not be considered normal. It will differ with your assumptions about a discount rate or risk associated with (not a cap rate), location, use…etc. I used 8% percent but you may want to adjust it to your yearly required return. Say 10% but ,your NPV will drop like wise as well as your IRR. You could discount every cash flow at a different rate. You may want to use a different discount rate for the reversion. The thinking behind it is that the property is older now and there for, will sell at a higher cap rate. This is the most accurate way to value cash flow…ie “Discounted Cash Flow Analysis”

This is no hocus pocus!!!

2

Mistake meant to modify

3

It looks like hocus pocus to me.

First of all, where are you going to find an accurate NOI for a $100,000 building? I can tell you from experience that it doesn’t exist. Owners of relatively small rentals don’t normally have detailed financial records. The owner of the 7 unit building that I just bought didn’t even know the names of all the tenants! He certainly didn’t have any financial records and he had owned the building since 1958. I have dozens of rentals and not a single owner had accurate financial records.

Sean, I’m not saying that this information couldn’t be valuable for large commercial deals. I would certainly hope that if someone had a BIG office building or large apartment building in NYC, that they would have accurate financial records stretching back many years. The same is not true of most small residential properties. As you could see in the previous post, JBaldwin has 30 something rentals (as I recall) and even he isn’t calculating NOI properly or considering all the VERY REAL expenses.

So, with relatively small residential rentals, you would be starting out with a questionable NOI (I’m being polite). Then, you’re guessing about the increase in NOI (which can easily decrease in the real world instead of increase). Then, you’re picking a discount rate out of thin air. That sounds like a bunch of assumptions and guesswork to me. In other words, hocus pocus!

Instead of all these shenanigans, I believe it is MUCH more useful to determine the cash flow right now! What really matters is whether the deal will make money NOW! After all, if I lose a bunch of money and go out of business in a year, all that figuring for years 2 through 5 was just wasted ink on a page. On the other hand, if the property cash flows properly today, and the NOI actually increases - ALL THE BETTER!!!

Mike

4

Can’t wait to see what propertymanager says about this.

This method is the most widely accepted financial method to approach value.

Says who. I’ve read stacks of books, talked with many, many bankers, other investors, evaluated 100’s of properties, looked over message boards such as this and never, ever have I seen anyone say that this is the “most widely…”

I think all this is the formula for IRR (right/wrong???). If that’s the case I will say that many people do use the IRR as their way to evaluate properties but usually it’s as simple as punching a few numbers into a computer.

And actually the 3 most widely accepted financial methods to approach value are:

  1. Cost approach - value of building and site
  2. Income approach - cap rates
  3. Direct Sales Comparison approach - comps

That info comes from the national assoc. of appraisers.

5

Sales
Income
Cost
Highest & Best Use

If you talking about an appraisal and “market value”… I’m talking about investment value or the value of the investment to the investor … big difference…

I also agree with property manager on the expense front. Many of the assumptions will come from your knowledge of the surrounding market and 50% seams fine to me if it includes capital improvements. You can also use your personal property management experience to pull from. There for it’s not like you are guessing, but are making a educated decision. I also agree that NOI may not increase, but if you buy right you can drive rents higher thus increase value. I also agree that you want the property cash flowing ASAP and buying right can insure that.