
10 Jul Building the cash flow for investment appraisal purposes
Investment Appraisal
Investment appraisal involves the estimation of future cash flows and discounting them at an appropriate rate. A simple example will be the appraisal of a stylised office property investment with just one tenant. Having said that, we need to understand key outputs from this process, i.e. PV, NPV and IRR. Specifically, you will need to be able to:
- Compound sums to work out what they will grow to
- Discount future sums to work out their value today
A variety of market, asset and client-specific information is needed, such as:
- Holding period
- Frequency of cash flows
- Lease contracts and current rent
- Market rent
- Growth forecasts and depreciation
- Forecast of exit yield / value
- Transaction and management costs
- Target rate of return
Extending the cash flow
Say we decide to hold until lease expiry. How does this change things? The key difference is at end of period what will happen. Particularly, at lease end, the building will be, say 30, years old. Will existing tenant stay in building now it is older? Can new tenants be attracted to the building? Do we need to undertake expenditure? Usually the model will assume that refurbishment is needed to attract new tenants and potentially a buyer.
Creating an appraisal
Assume that you are considering the purchase of an existing office property that is situated in the Mayfair area of London. What factors might impact on its future cash flows and value? What inputs will we need? You can access the schedule and lease terms for the reference building in EGi and CoStar, which are publicly available information. For example:
- Single-let or multi-let office building?
- Cash flows for single or several tenants must be projected
- Different tenant types and covenants
- Upcoming lease expiries to deal with
- What do we assume about these lease events?
- What will the terms of any new leases be?
- What do we assume about the vacant space?
- Asset may need expenditure during holding period
What else do you need?
- Rental levels
- Market rents for location and for similar buildings
- Rental growth
- Forecast for location and depreciation rate estimate
- All Risks Yield
- Current levels and projection of likely exit yield
- Management and transaction costs
- Target rate of return
- What return does the client require from this asset?
Summary
- Building the cash flow involves several different tasks
- Gathering information
- Market, Asset and Client-based inputs
- Projecting cash flows
- Combination of judgements and maths
- Discounting cash flows
- Outputs and recommendations
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