Top 5 Assumptions in CRE DCF Models
When you set up a Discounted Cash Flow (DCF) model for commercial real estate (CRE), how well it works depends all on the guesses you make. Even tiny tweaks in these guesses can change how you see your cash a lot. Here are the five key guesses to keep an eye on:
- Rent Growth Projections: Small shifts in how much rent grows each year (like 3% vs. 4%) can bigly change the Net Operating Income (NOI) and what the property is worth over time.
- Expense Growth Rates: Being right about costs is key, since costs due to inflation and other market things can change a lot.
- Capital Expenditures (CapEx): Guessing too low on CapEx can mess up cash flow and returns, more so if you plan to keep it for a long time.
- Exit Cap Rates: A small change in the exit cap rate can make the final worth of the property jump up or down a lot.
- Discount Rate: This rate, showing risk and the value of money over time, shapes the current worth of money to be made later. Even a 1% shift can really switch up values.
All these guesses link up, making it key to try out many ways and better your model with real market info and advice from pros. The aim is to make a real, smart model that helps make good money moves.
Lesson 1 - Assumptions for Real Estate Financial Modelling Case Study
1. Thoughts on More Money from Rent
Getting more money from rent is key in each plan that sees if an idea will bring in cash in the future. Guessing the rise of rents over time means thinking about the market, what renters want, and big money trends, all of which can change a lot in 10 years. These changes can lead to big gaps in total money made over time because of how they pile up.
In steady markets, people often think rents will go up 2% to 4% each year, but these rates can change a lot based on where or what the place is. Even a small rise by 1% - from 3% to 4% - can make a big difference in money made over ten years. Let's look at some common times this happens.
How It Changes Money Plans and Money Made From Investments
Assumptions on rental growth touch your Net Operating Income (NOI), which is key in saying how much a property is worth. A small 1% rise in rent growth doesn't just help the first year’s money - it builds up over time, making more money each year.
For example, think of a $10 million office spot that brings in $800,000 in rent each year. With a 3% yearly rise, that money grows to $1,074,000 by year 10. But with 4% growth, it goes up to $1,184,000 - a $110,000 yearly difference. Over the whole time, this means a lot more extra money and a much bigger selling price in the end.
The effect doesn’t end there. Higher rent growth also ups the building's final worth, as selling prices often use the last year’s NOI. This twin effect - on yearly money and the last selling price - makes rent growth a big deal in these cash plans. Knowing how changes affect results is key to seeing if the whole plan will work.
How Sensitive Results are to Changes in Expectations
These cash plans really react to changes in how much the rent is expected to grow. A 1% change in yearly growth rates can swing your Internal Rate of Return (IRR) 200 to 300 points. This could turn an okay investment into a great one - or the other way around, a good chance into a let-down. The longer you keep the place, the more these differences show because they add up.
Being too careful with growth guesses can undervalue a place a lot. For instance, if you guess 2% growth but the market does 4%, you might set the value too low by millions. On the other hand, guessing too high in a down market can cause big losses if the real results don't meet the high hopes.
To fix this, smart analysts test many what-if cases with different growth rates from 1% to 4%. This shows how difficult it is to guess and finds the balance point for the investment.
Wise Choices in Commercial Real Estate
To rightly guess rent increase, mix knowing the market well and having real hopes. Past rent growth in the area you're looking at is a good place to start, but you have to adjust for what’s happening now, what new buildings are coming, and bigger money trends.
Where a place sits counts for a lot. Big cities like San Francisco or New York can often push rent up over 5%, but smaller places might not even hit 2%. What sort of property you have is key too - apartment blocks in packed areas do better than office spaces where there are too many empty ones. How the lease is set up can change your predictions; long-term leases with step-ups are more stable than month-to-month ones.
You should also think about when leases end and the space between what is being charged and what could be. This makes sure your plans for growth make sense. Getting the mix right between hope and care is key - being too careful might cause you to miss out on good chances, but too much hope might make you pay too much. Use numbers from the local area, similar deals, and financial guesses to make sure your growth hopes are real, not just dreams.
2. How Costs Will Grow
After we think about how much rent we may get, it's key to guess how costs may go up to make a strong DCF plan.
How fast costs grow can change how much money a property makes (Net Operating Income) and its total worth. Just using normal rise in prices can lead to wrong guesses. Instead, it's key to look at changes in costs that are just for that property for better guesses.
Recent data show why this is key. From 2010 to 2020, costs in LIHTC homes went up by about 3.0% each year. By 2021, this jumped to 5.4%, while the housing cost index went from 2.2% to 8.5% in the same time[1]. These numbers show why it's key to look back at past cost data and think about what's going on in the market when making guesses.
Like guessing rent money, getting the cost guesses right is needed to reach the Net Present Value and Internal Rate of Return you want in real estate with big buildings. For help and tools special for this, think about using services from The Fractional Analyst, made to help real estate pros.
3. Predicting Capital Costs
Capital expenses (CapEx) are key in shaping cash flow without loans during an asset's time of hold [2]. They may also change returns with loans if more share money is needed [2].
It is key to get CapEx figures right to show the true value of an asset in a cash flow model (DCF). When CapEx is well-thought-out, it makes sure that money plans fit well with how cash will come in. This level of rightness is a main part of strong DCF work.
For those who want to know more, The Fractional Analyst gives DCF help aimed at adding right CapEx figures into your money plans.
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4. Exit Cap Rate and End Value
The exit cap rate is key in setting the end value of a place. It shows what might come in the market and helps fix the selling price when you let go of the property.
To find the end value, you split the last year's net cash flow by the exit cap rate you think will apply. Even small changes in the exit cap rate can hugely change the end value and things like the rate of return.
Yet, just using the current market rates to guess might be too simple. It's key to think of how market scenes and rates might shift when you pick your exit cap rate. Like with rent and costs, how right your guess on the exit cap rate is matters a lot.
When you work out exit cap rates, keep stuff like market phases, kind of property, and where it is in your mind. Places in main markets often have lower exit cap rates for less risk seen, while those in other markets might need higher rates.
How you plan to leave should also shape your guesses. For example, if you aim to move money to a similar spot, you might use a bolder guess. But, if you want to give money back to investors, a safe plan could be wiser.
The Analyst's DCF ways show how changes in the exit cap rate touch returns. Making these guesses better is a big step in making a strong and full CRE DCF way.
5. Setting the Discount Rate
The discount rate is key in DCF (Discounted Cash Flow) plans. It turns cash that will come in the future into cash as of today. Even small changes to this rate can greatly alter how good an investment looks, shifting from a big win to a risky move.
How Rates Change Cash Flow and Investment Gains
This rate shapes what investors will pay for future money. For example, a building set to make $1 million in NOI (Net Operating Income) in five years is worth $783,500 with a 5% discount rate. If the rate goes up to 8%, its worth drops to $680,600 - a $102,900 shift.
Most who buy commercial real estate figure their rates by adding a risk-free rate to a risk add-on. They often use the 10-year Treasury bond as a base, which now hangs around the mid-4% area. On top of this, risky parts add more, such as:
- Market risk: 2–4%
- Building-specific risk: 1–3%
- Hard-to-sell risk: 1–2%
For example, a top-notch office spot in Manhattan might call for a 7% rate, while a smaller, single-user plant spot could need 10% or more. These vary based on how safe the investors think the deal is, how sure they are about the renter, and how easy it is to sell the place later.
Small Rate Shifts Mean Big Value Changes
Just tiny tweaks in the rate can mean big shifts in value. Look at a $50 million property valued at an 8% rate. If the rate hits 9%, its value falls to $44.2 million - a 11.6% cut caused by just a 1% change.
This is why big investors dig deep into setting the right rates. They look at what similar spots sell for, talk to agents to feel out buyer moods, and check REIT data to back their thoughts.
Using loans makes this even bigger. A small 1% error in the discount rate can mess up return rates by around 4% if an investor puts in 25% of the money. These shifts show why it's vital to run deep what-if checks to get ready for different things that could happen.
Making Wise CRE Choices
With how much values swing with rate changes, testing plans is a must. Moving the rate by ±100–150 points lets investors see how different things could go.
Market swings matter too. When rate trends go up, investors tend to hike their rates to keep up. In calm times, checking once a year may be enough.
How an investor aims to make money also sways rate choices. Value-add investors, facing bigger risks with fixes or new builds, often work with rates from 10–14%. On the other hand, core investors who like safer, steady spots might lean towards rates around 6–8%.
Where you are is key too. Homes in big places like New York, San Francisco, or Washington, D.C. tend to have lower cut rates since more money moves there and more people want to buy. But, homes in small spots need higher rates because there are less folks looking to buy and it takes more time to sell them.
To help make choices, tools like The Fractional Analyst’s DCF models use what we call sensitivity checks. These tools let folks see how money might grow in different rate setups, helping them get a good look at possible results before they put in their money.
Ending Thoughts
It is key to get the five main ideas right when making DCF models in real estate. A small wrong step can mess up the results of a deal.
What makes this hard is that these ideas are linked. For example, too high hopes for rent growth, with too low costs, can make the income seem much bigger over time. Also, small mistakes in guessing the exit cap rate can make big changes in how much a property is worth, more so for big assets. That's why it is so good to have advice from those who know a lot.
Expert help is very needed to make these guesses better. Today's real estate world is tricky with changing wants from tenants, new ESG rules, and changing rates. You need to think sharp and know the latest to go through these problems. Sites like The Fractional Analyst are very helpful as they give special financial tips, advice from experts, and top tools through CoreCast. They help people not make usual mistakes and make their guesses better without needing to get full-time analysts.
No model can see the future for sure, but with strong ideas and help from experts, you can be ready for changes in the market and keep your money safe. The goal is not to guess without any mistakes but to make models that are real, well checked, and lead to good choices in investing, even when the market changes.
FAQs
Why should we change the discount rate with market changes, and how does it affect the value of an investment?
Changing the discount rate based on market conditions is key as it shows changes in risk and the wider economic picture. This change makes sure that future money flows are priced right. For example, in times when the market is unsure, a higher discount rate is often used. This makes the present value of future money flows go down, showing that there is more risk. But, when the market is steady, a lower discount rate is used, making the present value go up and showing a better setting for investing.
By keeping the discount rate able to change, pricing models stay on point and helpful. This lets investors make smart choices and value an asset’s worth right for today's market.