So, you want to build your first Discounted Cash Flow? Welcome! In this guide, we’ll walk you through the fundamentals of creating your first Discounted Cash Flow (DCF). Don’t worry; it’s less magic and more method.

What is a DCF?

A Discounted Cash Flow or DCF is a tool to assess the present value of future cash flows from a property. You buy a property on Day 1, sell it on Day 100, and have some costs and income in between. The DCF tells you what the present value is of each of those positive and negative cash flows. It’s a tool used by investors and more increasingly valuers, to assess what the asset’s value is today.

Key Components of a Discounted Cash Flow

The main three components of a DCF are the cash flow projection (ie your income), the terminal value (ie the sale price), and the discount rate (ie your target return).

Creating your first DCF

Building a cash flow requires a systematic approach, you need to have certain things in place before you can move onto the next bit. It is recommended that you have a specific asset in mind so that you can use all the property details within your cash flow, but you can of course also build a template cash flow with generic or made up assumptions.

1. Periodicity

Cash flows can be modelled annually, quarterly, or monthly (or daily if you really want but we don’t recommend it). For a real estate asset, using a quarterly model is the simplest way to create an accurate forecast.

2. Cash Flow

Start by ignoring your purchase and sale, and simply build up the income. Use combinations of IF AND and IF OR to put rental income between the lease start and end dates. You then need to make assumptions around the new lease and model that in the same way. In our models we show void and rent free in the rental income line so that we can be sure that everything is working how we want it to.

Do the same thing for an irrecoverable costs, making sure that the landlord is covering the service charge and rates for any vacant units. As you get into the complexity of this you can also add rates mitigation where applicable.

Add these lines together to get your Net Operating Income (NOI).

Below the NOI line, you should also consider things like letting fees, refurbishment and capex.

3. Terminal Value

Once you have the NOI, you can then use this to calculate your exit value. In real estate we generally use a yield or a multiplier on the contracted net rent to work out the exit value. Note the use of the word “contracted” – that’s why it’s helpful to show your rent free within your income section, as even though you aren’t actually receiving this rent, you should be capitalising it.

4. Discount Rate

The discount rate is the target return of the investor. If you are the investor then this is really easy to work out (rough rule of thumb is <5% for Core, 5-10% for Core +, 10-15% for Value Add, and 15%+ for Opportunistic, but obviously it depends on the condition of the market and the specific investor), for a valuer this is a bit more tricky as the assumptions need to be more market generic. You then apply this discount rate to your cash flows, based on the period that they happen, to give you the Net Present Value (NPV).

As you get more experienced then you can start to introduce more features into your discounted cash flow, making it more and more accurate.

What software should you use?

We predominantly do all our modelling in Excel as it gives you full flexibility to make as many changes as you want, and to add as much detail as you want. There are a number of other pre-made solutions out there, including:

• Pantera – this has a great user interface and, having worked with the team building it, includes a lot of features we have in our models. As all software platforms do, it still has it’s restrictions albeit the team are always open to upgrade suggestions!
• BuiltAI – a really clean looking platform designed by ex-investors. It handily connects you up to the latest market data so that inputting forecast assumptions is easy.
• Forbury – has a really easy Excel interface, making it familiar for lots of users. It’s been around for a couple of years, therefore is probably the most accurate, but in our opinion also the most restrictive.

As you embark on building your first DCF, remember that it is a structured narrative, where each detail contributes to the overall financial story of your property. From choosing the right periodicity through to calculating the investor’s target return, each step is a building block towards a more accurate valuation. Happy modelling!

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Thank you so much for reading. If you want to learn how to build a detailed Discounted Cash Flow from scratch, then check out our training courses: https://www.excelinproperty.com/training

If you are reading this before 11^th March 2024, then sign up to our EPIC: Bootcamp and gain exclusive free training from us: http://go.excelinproperty.com/epic_bootcamp