Net Present Value of Free Cash Flows

[Michael W.]

I'm moving this post from the general forum to this forum, I think it's more applicable here.

We are in the process of buying our first investment home. When I say in the process, I mean we have secured lending, have evaluated and attempted purchase of 1 candidate (couldn't close the deal) and are now moving on to another candidate that we like.

I've been reading around the forums about some of the financial evaluations and am working to understand why Net Present Value of free cash flows is not being used more in the evaluation of a property.

It is interesting to understand the CoC as an income statement percentage and it is certainly interesting to do some quick calculations with perhaps the 50% rule.

But until you take a series of cash flows, discount them by a Weighted Average Cost of capital, and determine if you can clear your next best alternative (stock market, paying down debt), how do you know if you really have a something that will make you money?

For me Free Cash Flow is the total actual dollars available after all expenses, mortgage payment, and accounting for the interest and depreciation tax shields. That bottom line is cash that I'm getting for whatever I put into the property in year zero.

In one of the properties the difference between replacing a roof in year 5 and replacing it in year 10 on the NPV was significant enough that it kept the deal from closing.

What is the opinion on using NPV and free cash flows to evaluate properties?

[Frank Gallinelli]

I have long been a proponent of doing thorough pro forma analyses of income-producing investments. I think DCF / IRR projections of best-case / worst-case / in-between scenarios are essential to making informed decisions. And I agree with Bryan that a lot of folks simply don't understand these metrics or are apprehensive about the math.

I've got a couple of recent articles where I discuss in detail why I think this type of financial analysis is important, and the issues I see with some of the short-cut alternatives. If you care to read them, here are the links:

The 50% Rule vs. Discounted Cash Flow Analysis

The Cash-on-Cash Conundrum, Part 1 and Part 2