A discounted cash flow (DCF) model for real estate is a method for estimating the value of an investment by taking projected future cash flows of a project and discounting them to zero (date of purchase) using a predetermined discount rate. The discount rate, which can be the same as an investor’s targeted IRR, can be difficult to determine, but it is still one of the best tools available for determining value on a real estate property investment. Commercial real estate leaders rely on DCF modeling to make confident, risk-aware decisions in a shifting market. The model offers a reliable framework for understanding the potential pitfalls and projected returns of a project, especially since DCF models can be updated with real-time data, ensuring that cash flow forecasts are and discount rates reflect current market conditions.
Modern deal management software can enable acquisitions teams to improve the speed and accuracy of their DCF analysis. Northspyre centralizes key data and automates insights, providing org-wide visibility and enabling more accurate models. The platform’s real-time dashboards allow your team to update DCF models quickly, implement competitive real estate investment strategies. In this blog, you’ll learn the basic components of a real estate DCF, and how technology can increase the accuracy of your financial modeling:
Core Components of a Real Estate DCF
Real Estate DCF consists of several basic components:
- Projected Income: The projected income, or projected cash flow, is how much income the property is expected to generate over time, including rental revenue, reimbursements, and any other income streams (such as parking or laundry machine accrual)
- Operating Expenses: The cost of owning and operating a building, including property management, maintenance, taxes, and insurance
- Capital Expenditures: The significant investments in the property, including major renovations or repairs
- Discount Rate: The required rate of return for the property, with considerations for the time value of the property and associated risks
- Terminal Value: The value of the property at the end of a projected holding period, including rental periods and the rental rate trend over time
Real estate teams who use Northpsyre’s development platform can reduce manual data entry and eliminate the need to make gut-level assumptions, meaning your cost inputs and important statistics, such as NOI, are up-to-date and reliable.
DCF models are part of the real estate underwriting process where the projected future income of a property is determined and then cash flow is discounted to determine the current value of a property. Essentially, DCF is a way of modeling the value of a real estate asset based on projections of how money will appreciate in the future. A discount rate is used to determine the current value of the property based on those future cash flow projections, and is commonly the asset’s desired or projected rate of return.
Many other real estate return on cost metrics must be taken into account when putting together DCF analysis, such as rental increases aligned with market values or other property value increases, repairs or maintenance costs, or capital improvements. The most difficult part of assembling a DCF model is determining accurate amounts for your future costs and cash flows, but once you have this information, the calculator to find the current value of a property is straightforward. Here’s what DCF modeling might look like for two common asset scenarios:
- Commercial development with stable tenant leases over five years will have a straightforward DCF model, as future rental income will be predictable. In addition, operating expenses or other costs are likely to remain stable. In order to determine DCF, you would include the annual cash flow over the five-year period and a projected sale price at the end (based on an assumed exit cap rate), discounted back today using an appropriate rate.
- Value-add properties needing capital improvements in year two would require more complex DCF modeling. The upfront capital costs for improvement could mean the early cash flows are negative or low, and the model must account for this potential lower income in the early years.
Accounting for Market Factors and Risk Adjustments
The discount rate used in your DCF models should be adjusted based on interest rates and market conditions. When interest rates rise or the market is volatile, the discount rate will need to be higher to account for reduced investor confidence and higher opportunity costs. This leads to a lower present value determination. As a result, the impact of federal interest rates on property valuations will play a fundamental role in your DCF modeling.
Yield on cost analysis, while offering a useful snapshot of a project’s return based on stabilized income and total project rate, provides one way of inputting into DCF analysis. In other words, if your DCF model shows a project will reach stabilized Net Operating Income (NOI) in year 3, you can then use that NOI to calculate yield on cost. Yield on Cost should largely be used to validate the assumptions you’re making in a DCF analysis, which offers a full picture of the project’s market value.
Inflation and cap rate changes can also directly impact valuation. Higher inflation can erode real returns and increase expenses, reducing future returns. High interest rates and market volatility are often behind high cap rates, and as these lower property resale values, can decrease the present value in a DCF model. Leveraging modern real estate development software can help you keep models grounded in real-time data so you can confidently adjust risk assumptions based on the latest market insights. Northspyre offers developers access to both historical project data and real-time updated current project data, allowing you to adjust models as you use the DCF method for valuation.
Practical Tips for Risk Scenarios
DCF modeling requires modeling cash flows to anticipate the best-case scenarios, such as strong lease-up and positive rental growth, to the worst-case scenarios, such as low tenant demand or unexpected capital improvements. You should also model a base scenario, with moderate tenancy and operational costs requiring a moderate investment. By doing so, your team will be able to make realistic assumptions and be prepared for any outcome. Your firm should also leverage modern real estate development software to recalibrate discount rates in response to shifts in interest rates, including changes in market dynamics, debt costs, or lower treasury yields.
Here are a couple of different market scenarios and how each might impact the discount rate.
Sunbelt market with forgiving discount rates: Strong migration to Sunbelt markets is driving demand, which means properties have higher valuations and lower risk premiums
Volatile office market needing higher risk: The uncertainty around office market occupancy and demand lingering from the impact of the pandemic means office assets need a higher discount rate to account for the elevated investment risk
Leveraging Automation and Real-Time Data
Automation can play a large role in reducing human error and increasing accuracy in DCF modeling. By minimizing or eliminating manual data entry, you will reduce the chance of spreadsheet errors or missed data inputs. The ability to pull real-time data, such as up-to-date interest rates, rent comparisons, or vendor costs, into your DCF model is another advantage automation offers. Outdated and error-prone Excel spreadsheets can create errors in your DCF modeling, siloing key project data in individuals’ workflows, and increasing the risk of human error.
Northspyre’s platform helps teams centralize data inputs and automate assumptions, leading to more reliable and efficient valuations across the acquisitions and development lifecycles. For example, cost segregation analysis in commercial real estate, a method in which an owner segregates aspects of an asset that can be depreciated over a shorter period than the standard 39-year time frame, can be used to refine DCF outputs. You can automate cost segregation analysis, allowing investors to accelerate the timeline for depreciation deductions and improve tax-related cash flow, especially in the early years of holding an asset. Integrating cost segregation analysis directly into DCF modeling means tax deductions will be reflected in net income projections, and you’ll have a more accurate valuation. Automation will also reduce manual input errors and speed up underwriting for your projects.
Northspyre’s platform can also play a role in your DCF modeling by giving your development team strategies for reducing early project costs. The platform helps you manage development costs and timelines more accurately, empowering you to create different budgeting scenarios, evaluate bidding opportunities, and consider historical performance insights starting in your early project planning stages. You can leverage the platform to access key vendor information, creating a competitive bidding environment that strengthens your negotiating posture and flags scope gaps to help you proactively prevent change orders. Northspyre Deal, which streamlines the acquisitions process, offers tools to build accurate pro formas without manual spreadsheets.
Key Do’s and Don’ts
Building a DCF model that helps you determine accurate project valuations can be as simple as following a couple simple Do’s and Dont’s.
Do:
- Integrate live cost data to align your DCF model with market shifts, pricing changes
- Build manual override checks to flag any questionable inputs that might be compromising the accuracy of your DCF model
Don’t:
- Rely on stale data that misrepresents current market conditions or jeopardizes the accuracy of your financial modeling
- Use scattered spreadsheets that increase the risk of siloing key data inputs or having version control errors
When to Use DCF vs Other Valuation Methods
Leaders in the development industry have many valuation models at their disposal, including cap rate, comps, or IRR-based models. Understanding when to use DCF modeling over other methods can help you make informed and confident decisions in your investment strategy. Here are a few situations where you might want to rely on DCF versus other simpler financial modeling techniques.
DCF is more accurate than simpler models in certain situations, such as when cash flow is likely to vary over time, risk is uncertain, or market conditions and timing are likely to impact profitability. For example, on a value-add development project, with income expected to ramp up after renovations or construction, DCF can capture the timing of capital improvements and uneven cash flow more accurately than a cap rate can. DCF can also account for market growth or uneven leasing, which more static models would overlook. You also may want to consider DCF models for projects where complex financing, such as tax incentives, is being leveraged. Projects built in markets with volatile economic conditions, such as rising interest rates or inflation, can also benefit from the in-depth modeling DCF allows.
In certain situations, cap rate or sales comps might be more appropriate. If the asset is stabilized, income is predictable, and market data is up to date and available, relying on these more static methods can still provide accurate information. For example, in a fully leased property with long-term tenants and little near-term risk, a cap rate is an efficient method to determine valuation. In a fast-moving market with plenty of recent and comparable transactions, using a sales comp can help you get an understanding of market benchmarks without having to build out a complex financial model. No matter which method your team decides to use, Northspyre can help you model multiple valuation paths in parallel and pivot quickly when market signals shift.
Rethink How You Model Real Estate Deals
DCF modeling is important for creating reliable and accurate valuations, allowing you to gain a strong understanding of a project’s potential profitability and make informed investment decisions. Even though there are more static methods for financial modeling, DCF is still one of the most accurate and reliable tools for setting a value on a property investment. Automation can play a key role in your DCF models, offering real-time data to use as inputs, eliminating the need for error-prone manual entry, enabling you to run different scenarios to understand best, base, and worst-case outcomes. Overall, using automation to inform how you model real estate deals will lead to faster and more informed investment decisions that will benefit your portfolio in the short and long term.
See how Northspyre helps acquisition teams streamline DCF modeling and make faster, smarter investment decisions.
