Discounted cash flow analysis is the foundational valuation methodology for income-producing commercial real estate and the backbone of institutional underwriting. The logic is straightforward: a property's value today is the present value of the cash flows it will generate over a defined holding period plus the present value of the sale proceeds at the end of the hold, all discounted at a rate that reflects the risk of the investment. What is deceptively simple in concept becomes subtle in execution, because nearly every input — cash flow growth, expense growth, capital reserves, exit cap rate, discount rate, lease-up assumptions — is a judgment call that materially affects the result.
A typical CRE DCF uses a 10-year holding period, though assumptions of 5, 7, or 15 years are common depending on the asset and the purpose. Each year's net operating income is forecast individually, reflecting the specific lease roll schedule of the asset: contractual escalations in existing leases, market rent on renewal or new leases, vacancy and downtime during lease-up, leasing commissions, and tenant improvement allowances. Recurring capital expenditures — the real ongoing spending required to keep the property competitive — are typically modeled as a reserve deduction from NOI rather than as episodic events, because recurring capex is not really optional over a ten-year hold.
The terminal value at the end of the holding period typically uses an exit cap rate applied to the NOI in the year following the end of the hold. Institutional convention is to set the exit cap rate at 25 to 75 basis points above the going-in cap rate to reflect the building's aging, the uncertainty of future market conditions, and the reality that compressed cap rates today may not persist indefinitely. The terminal value almost always represents 70% to 80% of the total DCF value — a fact that makes exit cap rate the single most important sensitivity in almost every institutional CRE DCF and explains why seasoned underwriters treat exit cap assumptions with particular scrutiny.
The discount rate — the weighted-average required return applied to the projected cash flows — is decomposed into a risk-free rate, a market risk premium, a property-specific risk premium, and sometimes an illiquidity premium. Unlevered DCF discounts before-debt cash flows at an unlevered required return and produces a valuation independent of capital structure; levered DCF discounts after-debt cash flows at an equity required return and produces an equity value. Both are used in institutional practice — unlevered for property-level valuation, levered for equity return analysis. Sensitivity analysis across rent growth, exit cap, and discount rate is standard practice, and experienced analysts present DCF results as ranges with explicit sensitivity tables rather than as single point estimates.
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