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Discounted Cash Flow and Market Value

Posted by capital on May 11, 2018
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As property managers we are sometimes asked by our clients to determine their property value. We most often use the Discounted cash flow (DCF) analysis to determine a realistic market value for our clients property. DCF analysis uses the concept of the time value of money to determine how much an investment held for several years into the future would be worth in present dollars. Calculating market value using DCF is a four step process.

Step 1: Forecast Net Operating Income(NOI)

We typically forecast NOIs using five-year holding periods. Projecting over periods longer than five year is more challenging because more assumptions are made and the figures become less reliable.

Step 2: Estimate Sales Proceeds

We estimate a terminal value, or what the property will sell for at the end of the holding period. This is done by using capitalization to divide next year’s NOI by a capitalization rate aka going out capitalization rate. Next year’s NOI is used because we are selling next year’s benefits. It’s important to subtract the cost of the sale from the terminal value to arrive at sales proceeds. The formula to estimate sales proceeds is  Terminal Value – Cost of Sale = Sales Proceeds. For example, for a five year holding period, the terminal value is estimated by dividing the projected NOI for the sixth year by the capitalization rate expected at that time. Sales costs such as brokerage fees are then subtracted to arrive at sales proceeds.

Step 3: Select Discount Rate

When estimating market value, the discount rate can be viewed as the market-driven return from the property. It includes the annual return from rental income plus any return from price appreciation. Many real estate managers consider the broader investment market to determine typical rates of return. It’s imporatnt that the discount rate be found from quality and accurate sources such as published surveys,lenders, and active market investors.

Step 4: Sum Discounted NOI’s.

Sum all of the discounted NOI’s plus the sales proceeds to determine the present market value of the property.

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