Published September 9, 2021
Discounted Cash Flow and Market Value
As property managers we are sometimes asked by our clients to determine their property value. We most often use the Discounted cash flow (DCF)
analysis to determine a realistic market value for our clients
property. DCF analysis uses the concept of the time value of money to
determine how much an investment held for several years into the future
would be worth in present dollars.
Calculating market value using DCF is
a four step process.
Step 1: Forecast Net Operating Income(NOI)
We
typically forecast NOIs using five-year holding periods. Projecting
over periods longer than five year is more challenging because more
assumptions are made and the figures become less reliable.
Step 2: Estimate Sales Proceeds
We
estimate a terminal value, or what the property will sell for at the
end of the holding period. This is done by using capitalization to
divide next year’s NOI by a capitalization rate aka going out
capitalization rate. Next year’s NOI is used because we are selling next
year’s benefits. It’s important to subtract the cost of the sale from
the terminal value to arrive at sales proceeds. The formula to estimate
sales proceeds is Terminal Value – Cost of Sale = Sales Proceeds. For
example, for a five year holding period, the terminal value is estimated
by dividing the projected NOI for the sixth year by the capitalization
rate expected at that time. Sales costs such as brokerage fees are then
subtracted to arrive at sales proceeds.
Step 3: Select Discount Rate
When
estimating market value, the discount rate can be viewed as the
market-driven return from the property. It includes the annual return
from rental income plus any return from price appreciation. Many real
estate managers consider the broader investment market to determine
typical rates of return. It’s importatnt that the discount rate be found
from quality and accurate sources such as published surveys,lenders, and
active market investors.
Step 4: Sum Discounted NOI’s.
Sum all of the discounted NOI’s plus the sales proceeds to determine the present market value of the property.
