One of the most useful economic decision-making tools for commercial real estate users and investors is discounted cash flow analysis. The first step in the DCF process is to reduce each alternative being analyzed to the amounts and timing of all the cash flows. Once each of the alternatives has been reduced, the net present value can be calculated. The analysis can be done on a before- or after-tax basis. This article focuses only on the applications of the NPV function, which is a key consideration for determining users’ occupancy costs.
The NPV function has many applications for user and investor decision making. The NPV function simply discounts all cash flows to present values using an appropriate discount rate and totals all of the present values to a single sum. The single sum resulting from performing the NPV function has different meanings and interpretations depending on the application and the decision being made.
The following examples demonstrate the NPV function calculation and how it is used for various real estate decisions. The four user application examples and the two investor application examples that follow are by no means inclusive of all real estate applications of the NPV function for economic decision making. In addition, the use of the NPV function for economic decision making is not limited to real estate — many businesses also use the NPV function to analyze the profitability of potential capital expenditures.
1. Comparative Lease Analysis
The NPV function may be used to compare lease alternatives with the same projected occupancy period using the appropriate discount rate to determine which alternative is the most economically favorable. The largest NPV, which indicates the lowest occupancy cost for the projected occupancy period, is the best economic decision. In most cases, the NPV calculation for each lease alternative results in a negative number, indicating a liability (cost of occupancy). In this case, the largest NPV is the smallest negative number, which indicates the lowest cost of occupancy for the projected occupancy period and the best economic decision. (See Table 1, Comparative Lease Analysis: User Cost of Occupancy.)
2. Lease vs. Purchase Analysis
The NPV function may be used to compare buying versus leasing space for a given time period using the appropriate discount rate to determine the most economically favorable alternative. The purchase alternative may be analyzed with or without using debt financing. The largest NPV, which indicates the lowest occupancy cost for the projected occupancy period, is the best economic decision. The NPV calculation for the lease alternative and the purchase alternative results in negative numbers, indicating that a liability (cost of occupancy) will be incurred for each alternative. In this case, the largest NPV is the smallest negative number, indicating the lowest cost of occupancy for the projected occupancy period. (See Table 2, After-Tax Lease vs. Purchase Analysis.)
3. Sale-Leaseback Analysis
The NPV function may be used to compare the economic impact of a sale-
leaseback decision: determining whether it is more economically sound to continue owning space or to sell and lease back the space. This example illustrates owner alternatives with and without financing. The largest NPV, which indicates the lowest occupancy cost for the projected occupancy period, is the best economic decision. The possible outcomes for the NPV calculations for the sale-leaseback analysis are more complicated than most of the other user NPV applications. The calculations could result in two positive numbers or two negative numbers, or either alternative could be a positive number and the other alternative a negative number. The latter would indicate that either or both alternatives could produce a positive financial benefit (positive NPV) of occupancy or a liability (negative NPV). The multiple results of the NPV calculations largely are due to whether there is debt financing in place on the property, which is illustrated in Table 3, After-Tax Sale-Leaseback Analysis. The best economic decision is still the alternative that produces the largest NPV — regardless of whether the largest NPV is the smallest negative number or the largest positive number.
4. Lease Buyout Analysis
The NPV function may be used to calculate the present value of all lease payments for the remaining lease term using the appropriate discount rate. The discounted value calculated is the maximum price the user should pay to be released from all future lease obligations. There are times when users no longer need the space they currently have leased. The decision these users face is whether to continue to make the periodic lease payments until the lease expires or pay the owner a lump sum to be relieved of all future lease obligations. (See Table 4, User Lease Buyout.)
5. Profitability at a Given Discount Rate
The NPV function may be used to measure the profitability of a potential investment at a given discount rate and/or determine the price adjustment needed to achieve a target yield. When the NPV calculation results in a positive number it means that the investor will achieve a higher yield than required if the investor pays the listed or asking price for the investment. The positive NPV also tells the investor how much more they could pay for the investment and still achieve the target or required yield. When the NPV calculation results in a negative number it means the investor will not achieve the required yield if they pay the listed or asking price. The negative NPV also demonstrates how much less the investor must pay for the investment to achieve the target or required yield. When the NPV calculation results in a zero value it means the investor will achieve exactly the target or required yield if they pay the listed or asking price. In Table 5, Investment Profitability at a Given Discount Rate, the investor could pay $107,148 ($100,000 + the positive NPV of $7,148) and achieve the target or required yield of 9 percent.
6. Investment Value
The NPV function may be used to establish the value of a future income stream for a specific investor with a specific target yield. Investment value is defined as the price a specific investor will pay for a specific investment. Investment value varies from investor to investor based on their individual investment criteria. The NPV function can be used to determine the value of a future income stream (investment value) using the specific investor’s target yield. (See Table 6, Investment Value at a Given Target Yield.)