When we wrote our series on how Our $50K Duplex Is Now Worth $97K, some readers were wondering why we weren’t interested in flipping the property and making a quick buck. Well, what it comes down to is that we think the long term cash flows that we’re going to get out of the duplex far outweigh the amount that we would have netted if we tried to sell it shortly after we bought it.
What Would A Flip Have Looked Like?
Immediately after we bought the duplex for $50K, we put about $8K into it, got it rented, and then it appraised for $76K (an appraisal I thought was a bit of a stretch). So if we had sold it then for, say, $70K, we would have been looking at net consideration to us of $70K minus a 6% realtor fee, so about $65.8K.
- Our costs were about $58K
- Would give an overall profit $7.8K
- But after 28% in taxes (short term capital gains are taxed as ordinary income), that’s only $5.6K
That’s not chump change at an almost 10% profit in about 5 months, but for the number of hours that we put into the duplex (and the number of cuts and electrocutions), we weren’t really ready to sell out for minimum wage (or less).
So instead of looking at it as what we could sell the duplex for in the open market, we tend to look at the duplex as what the cash flows will look to us over the usable life of the duplex. For this, we can use a nifty valuation method called a DCF.
[In case it's not obvious, this DCF analysis works for any stream of cash flows, so if instead of real estate you own some internet real estate that's bringing in cash - I'm talking to you, other bloggers - this is one way to estimate how much it's worth to you today!]
What’s A DCF?
DCF stands for Discounted Cash Flow, and the basic idea behind this analysis is that to understand what future cash flows are worth today, you need to figure out what you would need today to be able to generate that amount of cash at that future date. I know, it sounds a little confusing at first, but hear me out.
Let’s think about first it in terms of what you need today to generate a specific dollar amount at some fixed time in the future.
For example – Let’s say you want an investment to be worth $5,000 3 years from now. You are reasonably confident that you can generate a safe return of 5% over the next three years. (5% is an example, let’s not get into interest rates on cd’s here…)
To find out how much we need to start with, all we need to do is solve for X in the equation:
Thinking back to math class, we can solve this and see that $X = $4,319.19. So if we feel confident that we can get a 5% return over the next 3 years, we would only need to invest $4,319.19 today to have that $5,000 when we need it.
But the DCF goes the other way around, right? If we know our investment will throw off $5,000 in cash 3 years from now – what is that investment worth to us today?
In reality, this is the same problem that we solved in the example above, except no one has told us what percent return we think we could generate over the next 3 years. The example above, we assumed 5%, but this rate is something that we actually get to think about and choose for ourselves, and it’s called the discount rate.
So how did we solve for $X above? We calculated:
which is actually this formula:
But that was only for one year worth of returns three years in the future, so to calculate what ALL of the cash flow is worth over a period of many years, we calculate each year separately and add them up. For short-hand in this formula, = cash flow in year 1, = cash flow in year 2, etc… and = discount rate. So the discounted cash flow, or DCF, is just:
where is however many years forward you’re projecting.
The IRS lets you depreciate an investment property over 27 years, so I tend to take my DCFs out to n=27, and assume the property is “used-up”, with no value at that time. (Not really accurate in real life, but since that’s the way the tax-man looks at it – and it’s an underestimate of value – it works for us.)
DCF Step 1: Calculate Your Yearly Cash Flows
With any investment property, you should have a pretty good idea where your money is coming from and going to. So we have a spreadsheet set up that looks something like this. This table is a version of an Excel table that we used to calculate estimated yearly cash returns – the values are in $ thousands.
|Year||Rent Income||Maintenance Costs||Income Taxes||Yearly Cash Flow|
Some of the assumptions that go into it include:
- Rent initialized at $1.5K/month with an expected occupancy of 11 months/year.
- Maintenance costs include insurance, RE taxes, repairs, and other maintenance expenses.
- Rent and maintenance costs are currently estimated to rise at about 3%/year due to inflation, RE taxes set at 5% increases.
- Income taxes are calculated at a 28% marginal tax rate.
DCF Step 2: Determine Your Discount Rate*, r
There are a lot of fancy formulas out there for calculating your discount rate, r, that use unnecessarily complicated methods. (I’m talking about WACC, beta, and similar methods.) You should probably ignore all those fancy formulas.
What it really comes down to is what rate of return do you think you would reasonably be assured of earning over that time period if someone handed you a pile of money to invest now. We tend to think of it as “If we had this money in our pockets today, where would we invest it and what return do we think we could get there”.
- If you are very conservative, and would invest in cds, consider using the 10-year cd rate. The best 10-year cd I saw recently was 2.25%.
- If you think you’d likely drop the money into an S&P 500 fund, consider using the historical CAGR of the S&P 500, 7.37%/yr since 1950.
- If you think you’re likely somewhere in between, split the difference and calculate your DCF using r = 5.5%.
Everyone is not going to have the same answer, because we might all do different things with the money. The best answer is what you think you would do with the money and how much it would earn there. Be realistic. If last year’s return in the stock market was 30% (or a single stock), you’re kidding yourself if you think that any stock (or index) is capable of doing that 27 years in a row. (Eventually the stock would dominate the global economy if that were the case.)*
DCF Step 3: Plug the Numbers In
Starting from table that we made in Step 1, we can add 3 more columns in Excel in order to compare the Conservative, Risky, and Mixed DCF valuations at the same time.
|Year||Yearly Cash Flow|| Conservative
r = 2.25%
r = 7.37%
So, we can see that we expect our duplex to return $341.6 in after-tax cash flow to our pockets over a 27-year period. But what would someone have to pay us to make it worthwhile to sell the duplex?
- If we know we’re conservative investors, we use r = 2.25% and see that we would have to net $250.1K after taxes to have enough cash to generate the same $341.6 in cash flow that the duplex would return over the 27 years.
- The riskier S&P 500 option with r=7.37% shows that we would have to net $140.0K after taxes in the transaction.
- And the “Balanced” r=5.5% shows that a sale offer would need to net $169.7 in after tax profit to match the cash flows that the duplex will generate.
- Don’t forget! The taxes that would need to be added back to all these values are two-fold. 1 – the taxes at the time of the sale of the property, 2 – the taxes when you withdraw your investments for income.
* Note – the DCF can be pretty susceptible to the GIGO principle – that is, “garbage in, garbage out”. If you make unrealistic assumptions and then project them forward for almost three decades, the level of surrealism in your model is going to grow exponentially. Pretty soon you’ll start to see melting clocks everywhere… So please don’t do it!
Have you ever heard of or used a DCF before? What do you think of the concept of trying to figure out how much it would take to “buy” an equivalent stream of cash flows?