Shortcomings
Commercial banks have widely used discounted cash flow as a method of valuing commercial real estate construction projects. This practice has two substantial shortcomings. 1) The discount rate assumption relies on the market for competing investments at the time of the analysis, which would likely change, perhaps dramatically, over time, and 2) straight line assumptions about income increasing over ten years are generally based upon historic increases in market rent but never factors in the cyclical nature of many real estate markets. Most loans are made during boom real estate markets and these markets usually last fewer than ten years. Using DCF to analyze commercial real estate during any but the early years of a boom market will lead to overvaluation of the asset.
Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the principle "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on involves calculating the period of time likely to recoup the initial outlay.
Read more about this topic: Discounted Cash Flow
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