discounted cash flow: ratio analysis

© JR DeLisle, Ph.D.

Discounted Cash Flow:Ratio Analysis

byJames R. DeLisle, Ph.D.

March 20, 2014


Lecture Preview

• The Value Proposition• Frontdoor/Backdoor Models

DCF Prelude

• DCF: A Visual Overview• One Word: GiNiTiBtAtNR• Basic Inputs

Introduction to Discounted Cash Flow

• Schedule 1: Pro Forma Cash Flow• Schedules II-III: Depreciation and Loan Amortization• Schedules IV-V: Capital Gain Taxes and Net Reversion• Schedules VI: Financial Ratios

DCF Schedules

DCF MODELS: A VISUAL PERSPECTIVE


Equity Justified: PV of CF + PV Net Reversion

NIr

GIr

PV C

F

+


Net Reversion

TRCm

NIr

GIr

StabilizedNOI

Sales Price - Sales Exp

Net Reversion

Appreciation

Land Value

Depreciation

AmortizationMortgage

CG Appr x 15%

CG Depr x 25%

Pb

Net Sales Price


Equity Justified: PV of CF + PV Net Reversion

= Ej

NIr

GIr

Sales Price - Sales Exp - Tax on Sale - Mtg. Bal.

Net Reversion

PV C

F

+PV

NR


Cash Flow: The One Key Word

GI NI TI BT AT NR

Gross IncomeNet Income

Taxable Income

Before Tax Cash Flow

After Tax Cash Flow

Net Reversion

DCF CASE STUDY:INPUTS AND SCHEDULES

© JR DeLisle, Ph. D.

Real Estate Fundamentals


Cash Flow Variables and TRC/FD/BD Inputs

Total Replacement Costs

Income & Expenses

Debt Assumptions

Income Taxes

Terminal Value

Equity Assumptions

Land ValueBuilding ValueTotal Replacement Cost

Gross IncomeVacancy LossExpensesProperty Taxes

Loan-to-ValueMortgage Interest RatePeriodicity (Payments/YearLoan term (years) Depreciable Life (R=27.5; C=39) Capital Gain Tax Rate on Appreciation Capital Gain Tax Rate on Value

Marginal Tax RateEquity discount rateReinvestment rate

LandV 435,600$ BldgV 3,436,567$ TRC 3,872,167$

GI, GIC $468,557VacR 10.00%

ExpR, ExpC 10.00%PTXr, PTxC 8.00%

LV 80.00%Mr 7.50%Ppy 12

Term 30

SellExp 2.00%Ce 10.00%

MTxR 36.00%Ec 10.00%RIr 6.00%

4.00%

4.00%3.00%

Value Assumptions Terminal Value Method (1=App, 2=Cap) 2Appreciation Rate 2%Exit Cap Rate 10.00%

Selling ExpenseExit Cap Rate

DeprLife 39CGTxR 15.00%CGTxV 25.00%


Discounted Cash Flow and Financial Ratios

• Schedule I: Cash Flow

• Schedule II: Depreciation

• Schedule III: Loan Amortization

• Schedule IV: Net Reversion

• Schedule V: Capital Gain Tax

• Schedule VI: Financial Ratios


Schedule I: Cash Flow Overview

Cash Flow ComponentGross Income Less: VacancyEffective Gross Income Less: Expenses Less: Property TaxesNet Operating Income Less: Depreciation Less: InterestTaxable Income Plus: Depreciation Less: Principal ReductionBefore Tax Cash Flow Less: Income Tax Due Plus: Tax SavingsAfter Tax Cash Flow Plus: Net Equity ReversionAfter Tax CF + Net Reversion

CodeGI

VacEGIExpPtxNI

DeprIntTI

DeprPrin

BTCFItax

TSOIATCF

NRATCF+NR

Year 1468,557(46,856)421,701(46,856)(37,485)337,361(88,117)

(231,362)17,88288,117

(28,556)77,443(6,438)

071,006

372,880443,885

Year 2487,299(48,730)438,569(48,730)(38,609)351,230(88,117)

(229,145)33,96888,117

(30,773)91,313

(12,229)0

79,084545,118624,202

Year 3506,791(50,679)456,112(50,679)(39,767)365,666(88,117)

(226,756)50,79388,117

(33,162)105,748(18,285)

087,463

687,712775,174

Year 4527,063(52,706)474,357(52,706)(40,960)380,690(88,117)

(224,181)68,39188,117

(35,736)120,772(24,621)

096,151

824,014920,166

Year 5548,145(54,815)493,331(54,815)(42,189)396,327(88,117)

(221,407)86,80388,117

(38,511)136,409(31,249)

0105,160968,091

1,073,252


Schedule II: Depreciation

Schedule II: DepreciationYear 1 Year 2 Year 3 Year 4 Year 5

Total Replacement Cost 3,872,167 Less: Land (435,600)Beginning of Year Tax Basis 3,436,567 3,348,450 3,260,333 3,172,216 3,084,099 Less: Depreciation (88,117) (88,117) (88,117) (88,117) (88,117) Plus: Capital ImprovementsEnd of Year Tax Basis 3,348,450 3,260,333 3,172,216 3,084,099 2,995,981 Plus Land 435,600 435,600 435,600 435,600 435,600Adjusted Basis 3,784,050 3,695,933 3,607,816 3,519,699 3,431,581Accumulated Depreciation 88,117 176,234 264,351 352,468 440,586

Schedule II: DepreciationComponent Year 1

Total Replacement Cost 3,872,167 Less: Land (435,600)Beginning of Year Tax Basis 3,436,567

$3,436,567*(1/39) = $88,117

Less: Depreciation (88,117) Plus: Capital ImprovementsEnd of Year Tax Basis 3,348,450 Plus Land 435,600Adjusted Basis 3,784,050Accumulated Depreciation 88,117

Year 2

3,348,450(88,117)

3,260,333435,600

3,695,933176,234


3,097,734 Pb1(3,069,178) - Pb2

28,556 Pr

Schedule III: Loan Amortization

Factor Code Initial PaymentCompounding/Period m 12Term t 30Present Value PV 3,097,734Payment PMT $21,660Future Value FV $0Interest Rate I 7.50%

#/yr 12Annual $259,918

Code Initial Prin Bal.m 12t 29

PV 3,069,178PMT 21,660FV $0I 7.50%

Amortization Year 1Beginning of Year Balance 3,097,734 Mortgage Payment 259,918 Interest (231,362) Principal Reduction 28,556End of year balance 3,069,178

259,918 Pmt(28,556) -Pr231,362 Int

Calculate Payment

Calc. Principal Balance

Calc. Prin.Reduction

Calc. Interest


Schedule III(b): Loan Amortization

Year 1 Year 2 Year 3 Year 4 Year 5Beginning of Year Balance 3,097,734 3,069,178 3,038,405 3,005,243 2,969,507 Mortgage Payment 259,918 259,918 259,918 259,918 259,918 Interest (231,362) (229,145) (226,756) (224,181) (221,407) Principal Reduction 28,556 30,773 33,162 35,736 38,511End of year balance 3,069,178 3,038,405 3,005,243 2,969,507 2,930,996

Schedule III: Loan Amortization

Amortization Year 1 Year 2Beginning of Year Balance 3,097,734 3,069,178 Mortgage Payment 259,918 259,918 Interest (231,362) (229,145) Principal Reduction 28,556 30,773End of year balance 3,069,178 3,038,405


Schedule V: Capital Gain on SaleYear 1 Year 2

Capital Gain Tax on ValueGross Sales Price 3,512,303 3,656,656 Less: Sales costs (70,246) (73,133)Net Sales Price 3,442,057 3,583,523 Less: Original Cost Basis 3,872,167 3,872,167Capital Gain on Appreciation (430,110) (288,644)

CGTax on Appreciation 86,022 57,729Capital Gain on Accumulated Depreciation 88,117 176,234

CGTax on Accumulated Depreciation (22,029) (44,059)Total Capital Gain (Tax) or Saving 63,993 13,670Capital Gain Tax 0 0Capital Gain Saving to other Cap Gains * 63,993 13,670* If value is positive (Saving) this can be used against outside gains from other assets in current year. If savings exceed outside gains, they will be carried over future years.

Schedule IV: After Tax After Sale ProceedsCash Flow Component Year 1 Year 2Gross Sales Price 3,512,303 3,656,656 Less: Sales costs (70,246) (73,133)Net Sales Price 3,442,057 3,583,523 Less: Capital Gain Tax 0 0After Tax Sale Proceeds 3,442,057 3,583,523 Less: Mortgage Balance (3,069,178) (3,038,405)After Tax Net Equity Reversion 372,880 545,118

Schedule III: Loan AmortizationYear 1 Year 2

Beginning of Year Balance 3,097,734 3,069,178 Mortgage Payment 259,918 259,918 Interest (231,362) (229,145) Principal Reduction 28,556 30,773End of year balance 3,069,178 3,038,405

Schedule IV-V: CGTaxes on Sale & AT ProceedsSchedule IV: AT Proceeds

Schedule V: Capital Gain Tax On Sale If, CapGain * 15%

AccDepr * 25%


Schedule I: Cash Flow 1- 10

Cash Flow Component Year 1 Year 2 Year 3 Year 4 Year 5Gross Income 468,557 487,299 506,791 527,063 548,145 Less: Vacancy (46,856) (48,730) (50,679) (52,706) (54,815)Effective Gross Income 421,701 438,569 456,112 474,357 493,331 Less: Expenses (46,856) (48,730) (50,679) (52,706) (54,815) Less: Property Taxes (37,485) (38,609) (39,767) (40,960) (42,189)Net Operating Income 337,361 351,230 365,666 380,690 396,327 Less: Depreciation (88,117) (88,117) (88,117) (88,117) (88,117) Less: Interest (231,362) (229,145) (226,756) (224,181) (221,407)Taxable Income 17,882 33,968 50,793 68,391 86,803 Plus: Depreciation 88,117 88,117 88,117 88,117 88,117 Less: Principal Reduction (28,556) (30,773) (33,162) (35,736) (38,511)Before Tax Cash Flow 77,443 91,313 105,748 120,772 136,409 Less: Income Tax Due (6,438) (12,229) (18,285) (24,621) (31,249) Plus: Tax Savings 0 0 0 0 0After Tax Cash Flow 71,006 79,084 87,463 96,151 105,160 Plus: Net Reversion 436,872 558,789 687,712 824,014 968,091After Tax CF + Net Reversion 507,878 637,873 775,174 920,166 1,073,252

Year 10666,903(66,690)600,212(66,690)(48,909)484,613(88,117)

(203,950)192,54688,117

(55,967)224,696(69,316)

0155,379

1,820,6411,976,020


Teams

INTRODUCTION TO DCF RATIOS:KEY FINANCIAL INDICATORS


Schedule VI: Financial Ratios

Schedule VI: Ratio Analysis

Debt Coverage Ratio Default Ratio Profitability Index Before Tax Cash on Cash After Tax Cash on Cash Implicit Cap Rate Gross Income Multiplier Net Income Multiplier (P/E) Payback Ratio (w/o sale) Modified Payback (w/o sale) NPV Equity (sold/year) IRR if Sold/Year Modified IRR if Sold/Year Marginal Rate of Return

Year 11.300.730.52

10.00%9.17%

10.00%7.50

10.419.17%9.17%

($370,901)-42.68%-42.68%

Year 2 Year 3 Year 4 Year 51.35 1.41 1.46 1.520.71 0.69 0.67 0.650.75 0.92 1.06 1.20

11.79% 13.65% 15.59% 17.61%10.21% 11.29% 12.42% 13.58%10.00% 10.00% 10.00% 10.00%

7.50 7.51 7.52 7.5310.41 10.41 10.41 10.41

19.38% 30.67% 43.09% 56.67%19.93% 32.42% 46.78% 63.17%

($194,013) ($62,124) $49,674 $153,266-5.52% 6.69% 11.96% 14.76%-4.96% 6.63% 11.25% 13.48%40.62% 24.19% 18.70% 16.64%

CodeDCRDRPIBTCFATCFICrGIMNIMPBMPBNPVIRRMIRRMRR


Schedule VI: Financial Ratios

NIn Net Income in nth YearE1 Initial Equity Investment

ATCFn After Tax Cash Flow in nth YearBTCFn Before Tax Cash Flow in nth Year

NRn Net Reversion in nth Year = After Tax Sales ProceedsMVn Market Value in nth Year = Gross Sales PriceGIn Gross Income in nth YearNIn Net Income in nth YearIRR Internal Rate of Return

MIRR Modified Internal Rate of ReturnPV Present ValueRR Reinvestment RateFV Future Value

Debt Coverage Ratio NIn / MtgPayment Default Ratio Sum (Exp +Property Tax + Mtg Payments)n / GIn

Profitability Index [(PV ((ATCF)1-n + PV (NRn))] / E1

Before Tax Cash on Cash BTCFn / E1

After Tax Cash on Cash ATCFn / E1

Implicit Cap Rate NIn+1 / MVn

Gross Income Multiplier MVn / GIn

Net Income Multiplier (P/E) MVn / NIn

Payback Ratio (w/o sale) Sum(ATCF/E1)1 ->n Modified Payback (w/o sale) Sum ATCF1-> n + Reinvested/E1

NPV Equity [PV (ATCF 1->n) + PV (NRn)] - E1

IRR if Sold/Year [PV (ATCF 1->n) + PV (NRn)]IRR = PV(E1)IRR

Modified IRR if Sold/Year [(FV (ATCF 1->n)RR ) + (FV (NRn)RR)]IRR = PV(E1)IRR

Marginal Rate of Return [(ATCFn + NRn) - (ATCFn-1 + NRn-1)] / (ATCFn-1 + NRn-1)




Debt Coverage Ratio

• Interpretation– DCR provides a measure of the safety of the mortgage position, indicates the

cushion between required payments and NOI.– DCR’s should normally be 1.2 or more

• Equation

$0

$100

$200

$300

$400

$500

$600

$700

1 2 3 4 5 6 7 8 9 10

Thousands

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

MtgPay NI DCR

Year 1 Year 2 Year 3 Year 4 Year 5 Debt Coverage Ratio 1.30 1.35 1.41 1.46 1.52

NIn / MtgPayment

DCR: 1.3 Target




Default Ratio

$0

$100

$200

$300

$400

$500

$600

$700

1 2 3 4 5 6 7 8 9 10

Thousands

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

Fixed Payments GI DR

Sum (Exp +Property Tax + Mtg Payments)n / GIn

Year 1 Year 2 Year 3 Year 4 Year 5 Default Ratio 0.73 0.71 0.69 0.67 0.65

WhatDR is a measure of financial risk of real estate investments In essence it is the ratio of Fixed Costs to Gross Income

How Used:Establish maximum variation expectations vs. realizations

DR: .85 Target


Profitability Index

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

1 2 3 4 5 6 7 8 9 10

Thousands

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

Equity PV PVATCF + PVNR PI

WhatRatio of PV Receipts to PV Outlays Variation of NPV; shows when hit breakeven point

How Used:Determine economic viability; insights to minimum Holding Period

[(PV ((ATCF)1->n + PV (NRn))] / E1

Year 1 Year 2 Year 3 Year 4 Year 5 Profitability Index 0.52 0.75 0.92 1.06 1.20




Before Tax Cash on Cash Return

BTCFn / E1

Year 1 Year 2 Year 3 Year 4 Year 5 Before Tax Cash on Cash 10.00% 11.79% 13.65% 15.59% 17.61%

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

1 2 3 4 5 6 7 8 9 10

Thousands

BTCF Equity PV

0%

5%

10%

15%

20%

25%

30%

35%

1 2 3 4 5 6 7 8 9 10

BTCC

WhatMeasure of Nominal Return using Initial Investment as baseRatio of pretax distributable cash to initial investment

How Used:Determine economic viability and optimal Holding PeriodCompare alternative investments


After Tax Cash on Cash Return

ATCFn / E1

Year 1 Year 2 Year 3 Year 4 Year 5 After Tax Cash on Cash 9.17% 10.21% 11.29% 12.42% 13.58%

WhatMeasure of Nominal Return using Initial Investment as baseRatio of After Tax distributable cash to initial investment

How Used:Determine economic viability and optimal Holding PeriodCompare alternative investments

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

1 2 3 4 5 6 7 8 9 10

Thousands

ATCF BTCF Equity PV

0%

5%

10%

15%

20%

25%

30%

35%

1 2 3 4 5 6 7 8 9 10

BTCC ATCC


Implicit Cap Rate

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

$5,000

1 2 3 4 5 6 7 8 9 10

Thousands

NI MV

0%

5%

10%

15%

20%

25%

30%

35%

1 2 3 4 5 6 7 8 9 10

NOIn+1 / MVn

Year 1 Year 2 Year 3 Year 4 Year 5 Implicit Cap Rate 10.00% 10.00% 10.00% 10.00% 10.00%

Implicit Cap Rate

WhatRatio of NI in current period divided by end of year ValueMeasure corresponds with “cap rate” rule of thumb

How Used:Indication of relative pricing level; establish reasonableness of exit pricingFixed in this case due to application of Exit Cap to NOIn+1


Gross Income Multiplier

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

$5,000

1 2 3 4 5 6 7 8 9 10

Thousands

GI MV

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

1 2 3 4 5 6 7 8 9 10

GIMMVn / GIn

Year 1 Year 2 Year 3 Year 4 Year 5 Gross Income Multiplier 7.50 7.50 7.51 7.52 7.53

WhatRatio of current period Market Value to Gross Income

How Used:Rule of thumb comparison of alternative projectsRelatively stable in this case due to use of Exit Cap in estimating Sales Price


0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

1 2 3 4 5 6 7 8 9 10

NIM GIM

Net Income Multiplier

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

$5,000

1 2 3 4 5 6 7 8 9 10

Thousands

NI MV

MVn / NIn

Year 1 Year 2 Year 3 Year 4 Year 5 Net Income Multiplier (P/E) 10.41 10.41 10.41 10.41 10.41

WhatRatio of current period Market Value to Net IncomeAnalogous to the PE ratio in finance

How Used:An industry rule of thumb sometimes used to compare projectsRelatively fixed in this case due to Exit Cap on NOI


Payback Ratio (w/o Sale)

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

$5,000

1 2 3 4 5 6 7 8 9 10

Thousands

ATCF1-n Equity PV

0%20%40%60%80%

100%120%140%160%180%200%

1 2 3 4 5 6 7 8 9 10

PB

Sum(ATCF/E1)1 ->n

Year 1 Year 2 Year 3 Year 4 Year 5 Payback Ratio (w/o sale) 9.17% 19.38% 30.67% 43.09% 56.67%

WhatCumulative sum of After Tax Cash Flow/Equity RatioMultiperiod look at return of initial equity

How Used:Ratio that determines speed of return of equityUsed to compare risk vs. other investments


Modified Payback Ratio (w/o Sale)

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

$5,000

1 2 3 4 5 6 7 8 9 10

Thousands

FV ATCF ATCF Equity PV

0%20%40%60%80%

100%120%140%160%180%200%

1 2 3 4 5 6 7 8 9 10

Modified PB PBSum ATCF1-> n Reinvested/E1

Year 1 Year 2 Year 3 Year 4 Year 5 Modified Payback (w/o sale) 9.17% 19.93% 32.42% 46.78% 63.17%

WhatCumulative sum of FV of After Tax Cash Flow/Equity Ratio

How Used:Compare timing of returns against other alternativesUnderstand exposure period with reinvestment


NPV Equity

$0$200$400$600$800

$1,000$1,200$1,400$1,600$1,800$2,000

Thousands

1 2 3 4 5 6 7 8 9 10

ATCF NR

0

500

1,000

1,500

2,000

2,500

1 2 3 4 5 6 7 8 9 10

Thousands

ATCF + NR PVATCF + PVNR PV Equity

[PV (ATCF 1->n) + PV (NRn)] - E1

WhatCumulative sum of PV of Benefits less PV of Equity

How Used:Determines whether discount rate is exceeded at specified cost of capitalIf NPV is Positive (>1), indicates return exceeds required yield

Year 1 Year 2 Year 3 Year 4 Year 5 NPV Equity (sold/year) NPV ($370,901) ($194,013) ($62,124) $49,674 $153,266


Marginal Rate of Return

[(ATCFn + NRn)- (ATCFn-1 + NRn-1)] / (ATCFn-1 + NRn-1)

WhatThe net increase/decrease in total return relative to prior yearThe additional return from owning from period to period

How Used:Determining optimal holding periodProject has peaked when it drops off

1 2 3 4 5 6 7 8 9 10

$2,000

$1,800

$1,600

$1,400

$1,200

$1,000

$800

$600

$400

$200

$100

$637,873

$507,878

= $129,995

= 25.6%$507,878

$507,878

$637,873


Marginal Rate of Return

$0

$500

$1,000

$1,500

$2,000

$2,500

1 2 3 4 5 6 7 8 9 10

Thousands

0%

5%

10%

15%

20%

25%

30%

MRR

ATCF NR ATCF + NR MRR

1 2 3 4 5 6 7 8 9 10

[(ATCFn + NRn)- (ATCFn-1 + NRn-1)] / (ATCFn-1 + NRn-1)


Internal Rate of Return: Overview

Net Reversion

PV CF

PV NR

PV EQUITY $

PV EQUITY $

PV NR + PV CF

IRR

InterpretationRate that balances PV Outlays against PV Benefits;

NPV=0It assumes reinvestment at the IRR

Equation[PV (ATCF 1->n) + PV (NRn)]IRR = PV(E1)IRR


Internal Rate of Return

• Interpretation– Rate that balances PV Outlays against PV Benefits; NPV=0– It assumes reinvestment at the IRR

• Equation

[PV (ATCF 1->n) + PV (NRn)]IRR = PV(E1)IRR

14.76%

Year 1 Year 2 Year 3 Year 4 Year 5 IRR if Sold/Year IRR -42.68% -5.52% 6.69% 11.96% 14.76%

Year 1 Year 2 Year 3 Year 4 Year 5ATCF 71,006 79,084 87,463 96,151 105,160

NR 372,880 545,118 687,712 824,014 968,091ATCF+NR 443,885 624,202 775,174 920,166 1,073,252


Modified Internal Rate of Return

• Interpretation– Rate that balances PV Outlays vs. PV of the FV of Benefits– FV is ATCF reinvested at a specified rate and NPV=0– It may have multiple solutions, or may not converge

• Equation

[(FV (ATCF 1->n)RR ) + (FV (NRn)RR)]IRR = PV(E1)IRR



Net Reversion

PV CF

PV NR

PV EQUITY $


Year 1 71,006Year 2 75,266


[(FV (ATCF 1->n)RR ) + (FV (NRn)RR)]IRR = PV(E1)IRR

13.48%

Year 1 Year 2 Year 3 Year 4 Year 5ATCF 71,006 79,084 87,463 96,151 105,160

NR 372,880 545,118 687,712 824,014 968,091

Year 1 Year 2 Year 3 Year 4 Year 5 Modified IRR if Sold/Year -42.68% -4.96% 6.63% 11.25% 13.48%

$71,006 * (1 + 6%) = $75,266Reinvestment rate

154,350


GIGO Caveats in DCF Analysis

• Forecasted Cash Flows– Must Be REALISTIC Expectations– Neither Optimistic, Nor Pessimistic

• Discount Rate should be Opportunity Cost of Capital– Based on Ex Ante Total Returns in Capital Market– REALISTIC Property Market Expectations– Target Most Probable Buyer


Most Common Mistakes in DCF• Rent & income growth assumption is too high

– “We all know rents grow with inflation, don’t we!”?... – Remember: Properties tend to depreciate over time– Usually, rents within a building do not keep pace with inflation, long run

• Cap Ex &/or exit cap rate projection, are too low –– Capital expenditures typically average at least 10%-20% of the NOI (1%-

2% of the property value) over the long run.– Going-out cap rate is typically higher than going-in cap rate (older

properties are more risky and have less growth potential).

• Discount rate (expected return) is too high –– This third mistake may offset the first two– End result may be realistic estimate of current value,– No guarantee and often not true

Real Estate Finance

© JR DeLisle, Ph. D.Equity Justified: PV of CF + PV Net Reversion

= Ej

NIr

GIr

StabilizedNOI

Sales Price - Sales Exp- Tax on Sale- Mtg. Bal.

Net Reversion

PV C

F

+PV

NR

Real Estate Finance

© JR DeLisle, Ph. D.Net Reversion

TRCm

NIr

GIr

StabilizedNOI

Sales Price- Sales Exp

Net Reversion

Appreciation

Land Value

Depreciation

AmortizationMortgage

CG Apprx 20%

CG Deprx 25%

Pb

Net Sales Price

PV NR


Lecture Review

• The Value Proposition• Frontdoor/Backdoor Models

DCF Prelude

• DCF: A Visual Overview• One Word: GiNiTiBtAtNR• Basic Inputs

Introduction to Discounted Cash Flow

• Schedule 1: Pro Forma Cash Flow• Schedules II-III: Depreciation and Loan Amortization• Schedules IV-V: Capital Gain Taxes and Net Reversion• Schedules VI: Financial Ratios

DCF Schedules

discounted cash flow: ratio analysis

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