DCF Modeling: Cash Flow, Exit Value, and Discount Rate

DCF Modeling: Cash Flow, Exit Value, and Discount Rate

1. Explicitly Forecasted Cash Flows

A Discounted Cash Flow (DCF) model relies on projecting the future cash flows that an investment property is expected to generate. These cash flows are then discounted back to their present value, using a discount rate that reflects the risk associated with the investment. The accuracy of the DCF model is directly proportional to the accuracy of the cash flow forecasts.

• The cash flow forecast typically spans a specific investment horizon, often 5, 10, or 15 years.
• The length of the forecast period should be carefully considered, taking into account factors such as:
  • Lease expiry dates
  • Lease renewal periods
  • Break clauses in leases (and the probability of these breaks being exercised)

Cash flows can be explicitly defined as:

CF = Rental Income - Operating Expenses - capital expenditures❓❓ - Disposal Costs

Where each component has a number of considerations:

1.1 Cash Inflows

• Rental Income: The periodic income derived from rent payments by tenants. Rental income needs to be determined by lease contracts that have a number of considerations.
  • Consideration of the contract: Rents are received quarterly at the beginning of the period.
  • Rent Reviews: Incorprating rent reviews as defined within the lease contract.
  • Adjusted for Inflation: All future cash flows, other than currently contracted rental rates, need to be adjusted for inflation.

1.2 Cash Outflows

• Initial Investment Costs: This includes the purchase price of the property, as well as any associated costs such as loan points, fees, legal expenses, and transfer taxes.

• Operating Expenses: These are the ongoing costs of owning and managing the property, including:

  • Property taxes
  • Insurance
  • Utilities
  • Maintenance
  • Management fees
  • Marketing and leasing costs
  • Income and capital gains taxes

• Capital Expenditures (CAPEX): These are significant investments in the property that are made to maintain its value or improve its income-generating potential. Examples include:

  • Renovations and refurbishments
  • Roof repairs or replacement
  • HVAC system upgrades
  • Tenant improvements
  • Expenses associated with the disposal of the property (selling costs).

• Vacancy & Associated Costs: Properties aren’t always occupied. Vacancy represents a gap in potential rental revenue that needs to be accounted for.

  • Vacancy is determined by the number of months each space will remain vacant after lease expiry.
  • Carrying costs and real estate taxes that an investor will incur while the spaces are vacant
  • Estimated costs of refurbishing each space during the vacant period
  • Number of months of free rent tenants after the vacancy period

1.3 Timing and Frequency

• Timing is crucial: The timing of cash flows significantly impacts valuation.
• Frequency Matters: The more frequent the cash flow (e.g., monthly or quarterly vs. annually), the more accurate the valuation will be.
  • Experiment: Create a DCF model with annual cash flows and then modify it to use quarterly cash flows. Compare the resulting valuations. You should observe that using more frequent cash flows generally leads to a more accurate valuation, especially when interest rates are significant.

2. Exit Value (Terminal Value)

The exit value, also known as the terminal value, represents the expected value of the property at the end of the holding period. This value is crucial to the DCF model as it represents the cumulative value of all cash flows beyond the explicit forecast period. There are several methods for calculating the exit value, with the most common being the terminal capitalization rate (cap rate) approach.

• Formula: Exit Value = Net Operating Income (NOI) at Exit / Terminal Cap Rate

2.1 Terminal Cap Rate Approach

The terminal cap rate is applied to the stabilized NOI (Net Operating Income) expected at the end of the holding period.

1. Estimate NOI at Exit: Project the rental income and operating expenses for the year following the end of the holding period. The difference between these is the NOI.

2. Determine Terminal Cap Rate: This is the most critical and subjective step. The terminal cap rate should reflect the expected market conditions and risk profile of the property at the exit date. Factors to consider include:

   • Prevailing market cap rates: Research current cap rates for similar properties in the same location.
   • Expected future market conditions: Consider potential changes in interest rates, economic growth, and property supply and demand.
   • Property-specific factors: Assess the property’s age, condition, lease structure, and tenant quality.
   • Historical Data: Historical evidence indicates that terminal cap rates have varied dramatically from 3 percent to 12 percent.

3. Calculate Exit Value: Divide the estimated NOI at exit by the terminal cap rate.

   Example: If the expected NOI at the end of the holding period is $200,000 and the terminal cap rate is 8%, the exit value would be $2,500,000 ($200,000 / 0.08).

2.2 Growth Rate Approach

An alternative approach calculates the exit value based on a constant growth rate of income in perpetuity.

Formula: Exit Value = NOI at Exit / (Discount Rate – Growth Rate)

• NOI at Exit: The Net Operating Income expected at the end of the holding period (year N).
• Discount Rate: The discount rate used for the DCF analysis.

• Growth Rate: The assumed constant growth rate of the NOI in perpetuity. This rate should be conservative and reflect long-term sustainable growth prospects.

  • Typically this perpetual growth rate is tied to a risk free rate and other macroeconomic factors.
    Considerations:

• This method is more sensitive to changes in the growth rate and discount rate than the terminal cap rate method.

• The growth rate must be less than the discount rate for the formula to be valid.

2.3 Considerations and Refinements

• Physical Condition: Account for the anticipated physical condition of the property at the exit date. Will significant capital improvements be needed soon after the sale?
• Leasing Terms and Tenure: The remaining lease terms and the creditworthiness of the tenants will influence the exit value.
• Interest Rates and Property Yields: Consider potential movements in interest rates and property yields, which will affect the attractiveness of the property to potential buyers.
• All cash flows: Should be calculated by the value of the remaining rental payments as per the contracts in place at the end of the holding period. We will call these payments the ‘passing rent’.
• Vacancy and Refurbishment Costs: The value of any refurbishments, vacancy carrying costs, real estate taxes and leasing fees needed to bring the state of the property back to a long-run equilibrium.
• Market Rents: The value of all future expected market rents after the final refurbishment and carrying period.

3. Discount Rate

The discount rate is a crucial component of the DCF model. It represents the required rate of return an investor expects to receive for investing in the property, considering the risk associated with the investment. The discount rate is used to discount future cash flows back to their present value.

• The discount rate reflects the time value of money: A dollar received today is worth more than a dollar received in the future.
• The discount rate also reflects the risk premium: Investors demand a higher rate of return for riskier investments.

3.1 Methods for Determining the Discount Rate

Several methods can be used to determine the appropriate discount rate for a real estate investment. The most common are:

• Capital Asset Pricing Model (CAPM)
• Build-Up Method
• Weighted Average Cost of Capital (WACC)

3.2 Capital Asset Pricing Model (CAPM)

The CAPM is a widely used model for determining the required rate of return for an investment.

• Formula: Discount Rate = Risk-Free Rate + Beta * (Market Risk Premium)

  • Risk-Free Rate: The return on a risk-free investment, typically represented by the yield on a long-term government bond (e.g., 10-year Treasury bond). This compensates the investor for the time value of money. The risk-free rate is usually defined as a medium-term government bond, preferably with a time to maturity that corresponds to the holding period of the property being valued.
  • Beta (β): A measure of the investment’s systematic risk (or market risk) relative to the overall market. In the context of real estate, beta is difficult to estimate accurately because real estate is not traded as frequently as stocks.
  • Market Risk Premium (MRP): The difference between the expected return on the market portfolio (e.g., the S&P 500) and the risk-free rate. This represents the additional return investors require for taking on market risk.

• Limitations of CAPM in Real Estate:

  • Efficient Market Assumption: CAPM assumes an efficient market, which does not hold true for real estate. Real estate markets are often illiquid and characterized by information asymmetry.
  • Diversification of Specific Risk: CAPM assumes that specific risk can be diversified away. However, in real estate, specific property characteristics and location significantly impact risk and are not easily diversified.

3.3 Build-Up Method

The build-up method is a more intuitive approach that starts with a risk-free rate and adds premiums for various risk factors specific to the investment property.

• Formula: Discount Rate = Risk-Free Rate + Market Risk Premium + Liquidity Premium + Property-Specific Risk Premium

  • Risk-Free Rate: (Same as in CAPM)
  • Market Risk Premium: (Same as in CAPM) is associated with structural change risks for the overall property market.
    • The level of liquidity expected in the market at the time of final sale of the property
    • Failure to meet rental growth and market yield expectations
    • The risk of location, economic, physical and functional structural changes related to the property market
    • Legislative risks
  • Liquidity Premium: Reflects the relative illiquidity of real estate compared to other investments. This premium compensates investors for the difficulty and time required to sell a property.
  • Property-Specific Risk Premium: Captures the risks associated with the specific property being valued, such as:
    • Tenant credit risk (Tenant or operational default)
    • Lease term risk (Changes in lease terms at lease renewal dates)
    • Environmental risk
    • Management risk
    • Obsolescence risk (Costs of property ownership and management)

3.4 Weighted Average Cost of Capital (WACC)

The WACC is used when the property is financed with debt and equity. It represents the average cost of all capital used to finance the investment.

• Formula: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)

  • E: Market value of equity
  • D: Market value of debt
  • V: Total market value of the property (E + D)
  • Re: Cost of equity (required rate of return on equity), often determined using CAPM or the build-up method
  • Rd: Cost of debt (interest rate on the loan)
  • Tc: Corporate tax rate (if applicable)

3.5 Considerations and Refinements

• Market Conditions: Continuously monitor prevailing interest rates and market conditions, as they can significantly influence the appropriate discount rate.
• Property-Specific Analysis: Carefully analyze the specific characteristics of the property, its location, and its tenants to determine the appropriate risk premiums.
• Scenario Analysis: Use a range of discount rates to assess the sensitivity❓ of the valuation to changes in the required rate of return.
• Standardized Discount Rate: A single, standardised discount rate for all property investments.
• Property Class Discount Rate: Discount rates that vary by property class (for example, shopping mall, office, restaurant and gas station).
• Hurdle Rate: A hurdle rate based on minimum returns needed from an investment to adequately support total portfolio returns. These rates, typically used in private real estate investing, could be 20 percent, 30 percent or even 35 percent.

3.6 Practical Application and Related Experiment

1. Identify a Real Estate Investment Opportunity: Find a real-world example of a commercial property for sale or development. Gather data on the property’s historical and projected cash flows, financing details, and market conditions.

2. Determine the Discount Rate: Use the CAPM, build-up method, and WACC to calculate the discount rate for the investment. Research and justify your assumptions for each input variable (e.g., risk-free rate, beta, market risk premium, liquidity premium, cost of debt).

3. Create a DCF Model: Build a DCF model in a spreadsheet program (e.g., Excel) using the projected cash flows and the calculated discount rate.

4. Sensitivity Analysis: Conduct a sensitivity analysis by varying the discount rate and observing the impact on the property’s valuation.

   • Experiment: Vary the discount rate by +/- 1% and +/- 2% and note the changes in the present value of the asset.
   • Experiment: Create a data table to observe the impact of different terminal capitalization rates on the end value.

5. Scenario Analysis: Develop different scenarios for future market conditions (e.g., optimistic, base case, pessimistic) and assess the impact on the discount rate and the property’s valuation.