Discounted Cash Flow in Real Estate: What it is, When to use it, and Why it matters.

If you work in commercial real estate and don't fully understand what a discounted cash flow (DCF) is, you're not alone.

It’s one of the most important valuation techniques in the industry, but also one of the most poorly taught.

In this article, we’ll demystify the DCF model, explain how it works in plain English, and show you when (and when not) to use it.

What is a Discounted Cash Flow?

Discounted Cash Flow is a valuation method used to estimate the value of an asset based on its expected future cash flows.

The key principle behind DCF is that: money today is worth more than money tomorrow. This concept is called the “time value of money”. So rather than summing up all of the future income from a property, a DCF adjusts each cash flow to reflect what it’s worth in today’s terms.

In practice, this means:

·         Forecasting all the expected income and costs related to the property, including rent, service charge, capital expenditure, and terminal value

·         Applying a discount rate (usually your required rate of return) to convert each future cash flow into its present value

·         Summing those values to arrive at a total net present value (NPV)

The Discounted Cash Flow formula

There are different versions of the formula depending on complexity, but the basic logic looks like this:

DCF = CF1 / (1+r)^1 + CF2 / (1+r)^2 + ... + CFn / (1+r)^n

Where:

CF = cash flow in each period

r = discount rate

n = number of periods

In Excel, you’d typically build this using a timeline, line-by-line income and cost assumptions, and then apply the formula above using direct calculations or the NPV function.

What goes into a Real Estate DCF model?

For income producing assets, a DCF model will include:

• Rental income (passing rent, ERV, rental growth)

• Reletting assumptions and tenant incentives (voids, rent free periods)

• Operating costs (service charge, insurance, rates)

• Recoveries from tenants (service charge, insurance, rates)

• Capital expenditure (refurbishment, fit-out, etc)

• Leasing costs (agent fees, legal fees)

• Terminal value (sale of the property at the end of the hold period, sales costs)

Each of these inputs feeds into a line-by-line forecast of net cash flows over the hold period. Those cash flows are then discounted to present value.

How to choose a discount rate

The discount rate is one of the most critical (and subjective) assumptions in any DCF. In property, it’s usually derived from your target return or weighted average cost of capital (WACC), but it can also be informed by market data such as Government bond rates or internal rate of return (IRR) expectations from similar assets.

The higher the risk, the higher the discount rate:

• Core, stabilised asset in London: ~ 4%

• Value-add deal with planning risk: ~ 15%

When to use Discounted Cash Flows in real estate

When to use DCFs varies on whether you are looking at a property from a valuation or investment perspective.

From an investor’s perspective, you should use a discounted cash flow in most situations so that you take into account the time value of money. Investors should use DCFs in:

• Development appraisals – where delays to timeline can significantly impact the annual return

• Value-add investments – where leases are being actively managed and restructured, and therefore tweaks to various assumptions can be impactful

• Assets with complex structures where you want to be able to test different scenarios or sensitivities

From a valuer’s perspective, you should use discounted cash flows where appropriate. For example, for assets with multiple leases, where cash flows vary over time. You do not need to use discounted cash flows for stabilised assets with long leases and fixed income where simple cap-rate valuation models would suffice.

Why DCF can be better that other valuation models

Unlike other valuation models, DCF can be used for all assets that are valued using the income approach: investment, profits and residual. Discounted cash flows are explicit: they consider the full life cycle of the asset, providing greater detail and transparency than other valuation models. They also allow for:

• Scenario and sensitivity analysis

• Debt structuring

• Equity return modelling

In short, DCFs are more flexible and informative as a valuation tool, however they are also prone to error if not built and inputs are not researched properly.

Common mistakes in DCF modelling

• Hardcoded inputs: burying assumptions deep in formulas instead of making them visible and editable

• Unrealistic inputs/assumptions: all assumptions must be backed up by market evidence

• Discount rate mismatch: using a rate that doesn’t reflect the risk profile of the asset

• Ignoring capex or incentives: overstating or understating costs

• Incorrect treatment of terminal value: forgetting to include costs of sale, or overestimating the exit value

What is the difference between NPV and DCF?

• DCF is the model or technique – it forecasts and discounts the cash flows

• NPV is the outcome – the net present value of those cash flows

You use a discounted cash flow to arrive at the net present value.

Conclusion: DCF is powerful, but only if you do it right.

Discounted cash flow models are useful in a multitude of real estate situations, which is why they are so powerful and used so widely by investors, but they require clear thinking, good structure, and solid assumptions.

If you want to master DCFs and start modelling deals with confidence, try our free crash course or join the EiP Academy to go deeper.