Question

What are the three major types of mistakes made in the application of the DCF process, in real estate investment?

Answer 1

The Three major types of mistakes made in the application of DCF process in real estate investment are:

1. The Rent and Income Growth Assumption is too High

There is an inherent assumption that rents will increase with inflation over time .But, properties tend to depreciate(decrease) in real value(including inflation)over time.While the rents and income generated within the same(given or whose value we want to determine) building does not generally keep pace with inflation particularly in the long run and thus rents and income growth within a building are often taken as too high

2. The Capital Improvement Expenditure Projection and /or the the terminal projection rate is too Low:

In general:capital improvement expenditure(expenditure associated with improvement to the property) usually averages 10%-20% of Net Operating Income (NOI) or 1%-2% of the total property value in the long run.

The Going-out cap rate(ie. the cap rate associated with the sale of the property) is usually as high as the going-in cap rate(cap rate associated with buying of the property).The only exception to this is in case of older properties which are more risky and hence have a lower growth potential.

3.The Discount Rate (Expected Return ) is too high :

The discount rate or the expected return is taken as too high (this mistake may nullify the above two mistakes)