Discounted cash-flow analysis is the foundation for valuing all financial assets, including commercial real estate properties. The concept is very simple: a dollar today is worth more than a dollar in the future. Therefore, the value of future dollars is discounted. The timing of future cash flows and the likelihood that they will occur greatly impacts the price an investor may be willing to pay for an asset today. The real question is how accurate are your cash-flow projections? How accurate is the investor’s discounted value of future cash flows?
A Few Examples
If an office building is currently 70 percent occupied by a major credit tenant, you might assume that the cash flow is almost guaranteed. However, do you know what is happening in the tenant’s industry? Is this major tenant likely to be acquired, reduce its real estate footprint or succumb to competitive forces and go bankrupt in the next five years?
Similarly, are other building tenants from a certain industry that is being disrupted by technology or other market or industry changes? These questions warrant consideration when projecting a property’s cash flow. If the property is occupied by one major tenant, you need to have some understanding of the tenant’s industry and their competitive position. Major tenant risk is why some investors prefer properties with multiple tenants in such industries as health care and financial services, which tend to be less affected by outside trends and therefore generate fairly reliable rents.
Another example is a hotel that has enjoyed consistently high occupancy rates for the past five years or so. When you dig deeper, you see that much of its occupancy was derived from a nearby municipal convention center or arena that is being closed down for renovations or even permanently relocated. The disruption will undoubtedly skew occupancy levels, in which case you would reduce the projected cash flows and your bid for the property—or you might pursue a less risky investment.
Forecast Multiple Scenarios
With so many variables to consider, you’ll always find a gap between the forecast and the actual cash flow. By forecasting for multiple scenarios, you can be better prepared for the outcome and more accurately value the property. Take an educated guess at a base scenario and then create additional forecasts for 10 percent higher revenue and 10 percent lower. Quickly modeling different scenarios will give you a comprehensive look at the best and worst outcomes for any given period, so that you can make a knowledgeable decision about a property.
Also Check Out: Tenant Estoppel - What It Is and How It Works