What is Discounted Cash Flow Analysis in Commercial Real Estate?
Discounted Cash Flow Analysis, or DCF analysis, is a method used to determine the current value of a set of cash flows using a predetermined discount rate. In practice, DCF analysis is often used to compare the potential return from a commercial real estate investment to the estimated return from another investment, such as a stock, mutual fund, private equity investment, or another piece of commercial real estate.
How Discounted Cash Flow Analysis Actually Works
In practice, investors usually use DCF analysis to determine a property's net present value (NPV) at a certain discount rate, in order to compare it to a different investment. For example, if a property had an internal rate of return (IRR) of 9% a year, and we wanted to compare it to an alternative investment that yielded 7% year, that NPV calculation would use 7% as the discount rate. An investor could then use the NPV of the property to see how much additional cash they would be left with at the end of a certain period from investing in the property rather than the alternative investment option.
Of course, NPV can also be negative, if the discount rate exceeds the IRR for the property in question. This is why we say that IRR is the percentage that brings the net present value of a property to zero.