In real estate investment, Discounted cash flow (DCF) is a technique used to estimate the value of an investment asset by calculating the sum total of all present values of the asset's future cash flows.
The present value is a time value of money concept that discounts future cash flows to their equivalent value today. The idea behind the time value of money is one dollar today is worth more than one dollar tomorrow. To find the present value, we discount the future cash amount by a percentage rate. The rate is called a discount rate.
To illustrate, imagine you wanted to buy a house as an investment that you only intend to own for one year. The house is going to rent for $1000 per month payable at the beginning of each month. The tenant is going to pay all expenses including interest, taxes and maintenance. At the end of the year you are going to sell the house for $200,000.
At a discount rate of 5%, how much is the house worth to you as an investment?
| Date |
Present Value |
Cash Flow |
Description |
| January 1 |
$1000.00 |
$1,000.00 |
Monthly Rent |
| February 1 |
$995.85 |
$1,000.00 |
Monthly Rent |
| March 1 |
$991.72 |
$1,000.00 |
Monthly Rent |
| April 1 |
$987.60 |
$1,000.00 |
Monthly Rent |
| May 1 |
$983.51 |
$1,000.00 |
Monthly Rent |
| June 1 |
$979.42 |
$1,000.00 |
Monthly Rent |
| July 1 |
$975.36 |
$1,000.00 |
Monthly Rent |
| August 1 |
$971.31 |
$1,000.00 |
Monthly Rent |
| September 1 |
$967.28 |
$1,000.00 |
Monthly Rent |
| October 1 |
$963.27 |
$1,000.00 |
Monthly Rent |
| November 1 |
$959.27 |
$1,000.00 |
Monthly Rent |
| December 1 |
$955.29 |
$1,000.00 |
Monthly Rent |
| December 31 |
$190265.65 |
$200,000.00 |
Sale (Reversion) |
| Estimated Value |
$201,995.53 |
|
|
Using the discounted cash flow approach, we can see from the table that the value of the home as an investment is $190265.65. We simply totaled the present values of the rents collected plus the sale proceeds at the end of the year.
The discounted cash flow technique is useful in evaluating investments with complex cash flows over multiple periods of time. Cash flows can be either positive or negative over the holding period. The cash flow at reversion is the cash proceeds when the asset is sold at the end of the holding period.
The discounted cash flow approach depends on certain variables and assumptions that need to be paid attention to. First, the discount rate is based on the judgement of professionals performing the analysis. An analysis of comparable sales can help establish an appropriate discount rate.
Second, the discounted cash flow approach assumes to know what the future rents and sales price will be. Growth rates may be applied to rent over the holding period that are forecasts made by professionals. The DCF also forecasts the future sales price. It should be kept in mind that no one has a crystal ball, and there is a subjective aspect to the discounted cash flow analysis.