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Discounted Cash Flow NPV assumptions on return and inflation

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1. A big challenge with the NPV is the assumptions on the return and inflation. This is less of an issue if we are buying a $100,000 machine with a 5 year life. Real estate however is a long term investment.

- How do you estimate inflation over 5 years, 10 years and up to 30 years?
- Nobody has a crystal ball and if you estimate inflation staying flat at 2-3%, but it jumps to 8%, it destroys your projections. How do you protect yourself from this?

2. Another challenge we have with the discounted cash flow methods, specifically NPV, is estimating cash flows. In commercial real estate vacancies are hard to predict and can leave a huge gaping wound in cash flow. In this downturn I am sure you have all witnessed some units that have been 50% empty for 3 years or more. I doubt that the investors anticipated that.

- How do you estimate a vacancy risk factor in your cash flow analysis?
- Does sensitivity analysis help with this? If so how?

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Solution Summary

Your tutorial is 464 words and three references. The estimation issues in assumptions are discussed. Two tables are given showing that real estate does not correlate with inflation even if you could estimate it. Strategies are discussed.

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Question 1.

- How do you estimate inflation over 5 years, 10 years and up to 30 years?

In real estate, there are two classic ways to incorporate inflation in NPV analysis. First, you increase the value of selling the real estate at the end of the project by the impact of inflation assumptions. This changes the terminal cash flows when the real estate is sold, leaving it higher with more extreme inflation or not much higher with low inflation. Second, you adjust the expected rents and property maintenance costs by the inflation factors. That is, the rental income and property taxes, insurance, and repairs will also be impacted by inflation across the life of the project.

Now, how to you figure the amount of the inflation? That is the tough part! You can use historical rates but it is hard to know what the macro and micro forces will be that impact inflation. Look at the table at the end of this. Inflation has a bell curve but it has a long tail upwards too! And real ...

Solution provided by:
Carol Sargent, PhD
Education
  • BSc, University of Virginia
  • MSc, University of Virginia
  • PhD, Georgia State University
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