© JR DeLisle, Ph.D.
Discounted Cash Flow:Ratio Analysis
byJames R. DeLisle, Ph.D.
March 20, 2014
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
Equity Justified: PV of CF + PV Net Reversion
NIr
GIr
PV C
F
+
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph. D.
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%
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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%
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
Teams
INTRODUCTION TO DCF RATIOS:KEY FINANCIAL INDICATORS
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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)
© JR DeLisle, Ph. D.
Real Estate Fundamentals
© JR DeLisle, Ph. D.
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
© JR DeLisle, Ph. D.
Real Estate Fundamentals
© JR DeLisle, Ph. D.
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
© JR DeLisle, Ph.D.
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
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Real Estate Fundamentals
© JR DeLisle, Ph. D.
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
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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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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)
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
Modified Internal Rate of Return
Net Reversion
PV CF
PV NR
PV EQUITY $
© JR DeLisle, Ph.D.
Year 1 71,006Year 2 75,266
Modified Internal Rate of Return
[(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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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
© JR DeLisle, Ph.D.
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