Discounted Cash Flow Analysis

[Richard Haiber]

Quick question on discounted cash flow analysis for anyone who has any input on the topic.

Say we are dealing with the following hypothetical scenario:

T12 Actual Income: 1,000,000

T12 Actual Expenses: 475,000

T12 NOI: 525,000

Then say I'm assuming a 2% NOI increase per year for the next 5 years:

Yr1 NOI = 525,000

Yr2 NOI = 535,500

Yr3 NOI = 546,210

Yr4 NOI = 557,134

Yr5 NOI = 568,276

So, this gives us:

Year 1 CF = 210,000

Year 2 CF = 220,500

Year 3 CF = 231,210

Year 4 CF = 242,134

Year 5 CF = 253277 + 2,300,000 = 2,553,277

Total CF = 3,457,121

CFs were derived because my debt service on this property is  could be roughly 315,000 per year (5,830,000 purchase price with 25% down pmt and 6% interest over 30yr amortization).

That would leave roughly 4,000,000 as pay-off for the loan after 5yrs. of making P&I payments.

With a yr5 NOI = 568,276, that would give me a property value of roughly 6,300,000 using the same 9% cap that I bought with for simplicity's sake and a sale profit of roughly 2,300,000 (as reflected in the total Yr5 CF above).

Then say throughout my ownership I spend 500,000 total on cap ex to fix roofing, hvac units, etc. so say it worked out to 100,000/yr deducted from my CFs:

Now those numbers are fine and dandy, but I'm looking to see if I'm correctly applying discounted cash flow analysis as follows:

Actual CFs                               Discounted CFs

110,000                 (Yr1)                 98,113

120,500                 (Yr2)                 96,244

131,210                 (Yr3)                 94,128

142,134                 (Yr4)                 91,792

2,453,277              (Yr5)                 1,807,957

2,957,121             (Total)               2,188,234

*These CFs include cap ex deductions of 100k/yr

So, discounting CFs and considering cap ex gives me a difference of: 768,887 between the two columns.

Does this mean my IRRs are as follows?

IRR (actual CFs): 12.29%

IRR (discounted CFs): 5.06%

That's a huge difference and seems like the investment isn't worthy when considering discounted CFs. Or am I calculating discounted CFs wrong/using them wrong when trying to analyze a property?

If I'm out in left field I hope someone can help get me back into position as I'm here to learn.

***This is also all pre-tax as well.

[Frank Gallinelli]

Richard -

Looks like a couple of points of clarification might be in order:

You can do an IRR calculation using either the annual NOI along with the sale-year reversion (i.e., selling price). This is called an unlevered IRR as is typical of the method used by appraisers.

Alternatively, you can use the annual cash flows along with the proceeds of sale (i.e., the net after mortgage payoff). This is called the levered IRR and is more commonly used by investors because they want to compare different potential property investments that they intend to finance.

In either case, you must also take into account the initial cash investment. Without that, you cannot perform a correct IRR computation. You do not take individual discounted cash flows and then perform the IRR calculation, because that would be discounting the same cash flows twice.

In regard to the discount rate for a DCF pro forma, understand that the purpose of the IRR calculation is to find the exact discount rate that would make the present value of the future cash flows equal to what you paid for them. In other words, what is the rate that makes the NPV equal zero? Or yet another way of saying this, what is rate that makes the PV of the future cash flows equal to the cash invested?

It makes no difference whether the property is residential or non-residential. The entire DCF / IRR process is an analysis of the income stream and can be applied to any investment that involves an initial cash commitment, periodic cash flows, and a final cash from disposition of the investment.

Hope this helps.

Frank