What is a DCF analysis in real estate modelling?
How you answer questions like this can be the key to landing a position in real estate rather than re-entering the applicant pool.
By the CRE Modelling team
It is the valuation method every modelling test is built on, so it is worth being able to explain it in two sentences and then show it.
What is DCF analysis?
Discounted cash flow (DCF) analysis is a valuation method used to estimate the attractiveness of an investment based on its expected future cash flows, discounted back to their present value.
What it tells you
- Valuation accuracy: what is the intrinsic value of the property based on projected cash flows?
- Investment viability: does the present value of expected cash flows exceed the initial investment cost?
- Financial metrics: how do we calculate net present value (NPV) and internal rate of return (IRR) to assess the investment’s performance?
NPV and IRR, in plain words
Net present value is what the future cash flows are worth today, at the return you require, less what you pay. A positive NPV means the deal earns more than you require; a negative one means it earns less.
The internal rate of return is the discount rate at which the NPV is exactly zero: the return the deal actually earns on the money in it. Compare it with the return you require and you have your answer.
A three-year example
Buy for £10.0m, collect £0.6m of NOI a year, sell for £10.5m at the end of year three. You require 8 percent:
| Year | Cash flow | Discount factor | Present value | |
|---|---|---|---|---|
| 1 | 0 | –£10.00m | 1.000 | –£10.00m |
| 2 | 1 | £0.60m | 0.926 | £0.56m |
| 3 | 2 | £0.60m | 0.857 | £0.51m |
| 4 | 3 (NOI plus sale) | £11.10m | 0.794 | £8.81m |
| 5 | NPV at 8% | –£0.12m | ||
| 6 | IRR | about 7.5% |
At 8 percent the deal is just short: it earns about 7.5 percent. Either the price comes down, the exit goes up, or you walk away.
Prepare thoroughly and start early with your technical skills to successfully break into real estate.