O
ne 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.
T
he 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.)