Real Estate Valuation: Part 3 (Discounted Cash Flows)
This approach is called Discounted After-Tax Cash Flow Approach. This method is used as a supplement to the other valuation methods, such as cost, sales, and income approach.
Under this approach, the investor calculates the net present value of after-tax cash flows from the property discounted by his required rate of return. For the investment to be worthwhile, the NPV of cash flows should be positive. Alternatively, the IRR should be higher than the investor’s desired rate of return.
Numerical Example
An investor is considering purchase of a property now and selling it after a period of 5 years. The details of the property and its financing are provided below.
Property Purchase Details
| Property Purchase Price | 1000000 | |
| Equity | 25% | 250000 |
| Required Cost of Equity | 12% | |
| Debt | 75% | 750000 |
| Debt rate (p.a.) | 8% | |
| Interest is Tax-deductible | Yes | |
| Straight Line Depreciation | 5% | 50000 |
| Mortgage Payment | 66621 | |
| Marginal tax rate | 31% | |
| Year 1 NOI | 100000 | |
| NOI Growth Rate | 10% |
The property sale details are provided below:
Property Sale Details
| Property sold after (Years) | 5 |
| Capital gains tax rate | 20% |
| Sale Price (Forecasted) | 1200000 |
| Property Sale Expenses as a % of sale Price | 5% |
Result
Using the Discounted After-tax Cash Flow approach, the NPV of this project is positive ($78,098). Therefore, the investor should invest in this project.