An income property may look very attractive as an investment
at first glance. Cash flow and property value are produced by numerous
variables, and changes to any one variable can easily change the whole
equation. Cash flow and property value are sensitive to change.
As a sophisticated real estate investor, you find an
80%-occupied, 20-suite office commercial building for sale, priced at $2.5
million. You are given a professional package of brochures, which presents the
property attractively. You focus on the pro forma of the building, which is
given over a ten-year period. You also notice in the brochures that the seller
has used a discount rate and a terminal capitalization rate to value the sale
price of the property.
What risks do you foresee in purchasing this property? What
measures would you take to manage these risks? Will these risks affect the
price that you would offer? If so, how would they affect your pricing decision?
If not, what factors would contribute to your pricing decision?
Part 2: Discounted Cash Flow Analysis
In the discounted cash flow method, the discounted and
terminal capitalization rates are often applied to cash flows over a period of
five to ten years in income-producing real estate valuation. In addition, for
sensitivity financial analysis, the income and expense items are also projected
over the same period based on different scenarios, which, in turn, change the
real estate valuation.
What are the pros and cons of using such an approach to
justify your application for a loan from a lender to fund your real estate
project? How would you improve such an approach in order to increase your
possibility of securing the loan?
