Application of Discounted Cash Flow

Building upon the previous articles explaining the use of Valuation and Investment tables and how Discounted Cash Flow and Net Present Values work, we are now looking at how we can establish the true return on a property according to an assumed rate of growth and expected rents over a particular term.

This technique is known in financial circles as Internal Rate of Return (IRR), whereas property professionals refer to it as Equated Yield.

A Net Present Value appraisal allows an analysis of expected rents over the term of a lease and can produce an end figure that shows a profit or loss according to an expected rate of return.  To use the example in the article on DCF (see below), an investor pays £100,000 for the expected return of £30,000 at the end of years 1 and 2, and £40,000 at the end of years 3 and 4.  However he is borrowing the entire initial capital sum at an interest rate of 12% per annum.  Is the investment worth pursuing?

The table shows that the investor will end up with a profit of £4,585.00 after the costs of borrowing are taken into consideration.   Whether this is worth his effort or not is not relevant to us at this point, it does show however that as long as the return exceeds 12%, the remainder is profit.

So what if we have to find the actual return on an investment?   It’s all very well just ensuring that the return exceeds a certain level, but what if we need the precise figure that the investment will return?  We use the equated yield method.

It can be stated that as the NPV value gets closer to zero, the adopted yield figure (for the calculation) will be closer to the true return.  For example if the required return was placed higher at 14%, the profit would be absolutely minimal:

The NPV at this rate is clearly much closer to zero.  This signifies that after the negative and positive cashflows have been accounted for, the actual return on the investment is very close to 14%.

Calculating the actual equated yield figure is initially a process of trial and error.  This is because 2 trial rates should be used (these can actually be quite far apart) so that the true rate ends up somewhere in between them.

Again, using the example above, we know that the true rate will be very close to 14%, but for the purposes of demonstration a higher rate of 16% will be adopted and the lower rate of 12% will be re-used.

Clearly the resulting NPV figure is a negative one.  The effect of this is that the investment will make a significant loss if a return of 16% is required.  It does however, provide us with an upper rate with which to calculate the true investment return (or equated yield figure).

In order to calculate the equated yield, an equation is used:

Note:  LTR – Lower Trial Rate; HTR – Higher Trial Rate.

Therefore we can establish that the actual return on the original investment is 14.1%

When applying this technique to the context of a lease, the expected returns are incorporated and if the lease is expected to include a particular pattern of rent reviews (for example 5 yearly) the expected rate of rent increase should also be incorporated.

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