Key Takeaways
- Discounted after-tax cash flow values investments by accounting for income, capital costs, and taxes.
- It is commonly used in real estate to assess investment potential and profitability.
- Accounting for taxes and depreciation provides a realistic view of an investment’s attractiveness.
- A profitability index over one suggests the investment’s present value exceeds its cost.
- The approach adjusts future income streams to present value using a discount rate.
What Is Discounted After-Tax Cash Flow?
The discounted after-tax cash flow method values an investment according to the income it generates and accounting for the cost of capital and any taxes. In that way, discounted after-tax cash flow is similar to simple discounted cash flow (DCF), but with taxes factored in. It plays an important role in assessing investment viability and calculating potential returns in real estate.
How Discounted After-Tax Cash Flow Works in Real Estate
The purpose of a discounted cash flow analysis is to estimate the money an investor would receive from an investment, accounting for the time value of money. The time value of money assumes that a dollar today is worth more than a dollar tomorrow because it could be invested and earning money in the meantime.
The discounted after-tax cash flow approach is mostly used in real estate valuation to determine whether a particular property is likely to be a good investment. When using this valuation method, investors consider depreciation, the tax bracket of the person or entity that will own the property, and any interest payments on the capital required to make the purchase.
After calculating the net cash flow from a property each year, with taxes and financing costs factored in, the cash flow is then discounted at the investor’s required rate of return (RRR) to find the present value of the after-tax cash flows. Required rate of return, also known as a hurdle rate, is often determined by the investor’s weighted average cost of capital (WACC), or how much the investor must pay to borrow money. If the present value of the after-tax cash flow is higher than the cost of investing, then the investment may be worth making.
Since the discounted after-tax cash flow is calculated after taxes, depreciation must be accounted for in determining the tax cost, even though depreciation is not an actual cash flow. Depreciation is a non-cash expense that reduces taxes and increases cash flow. It is usually subtracted from net operating income to derive the after-tax net income and then added back in to reflect the positive impact it has on the after-tax cash flow.
Discounted after-tax cash flow is also used to calculate the discounted payback period of an investment, allowing an investor to estimate the length of time it would take them to recover the investment’s initial cost.
Calculating Profitability Using Discounted After-Tax Cash Flow
Discounted after-tax cash flow can be used to calculate the profitability index, a ratio that evaluates the relationship between the costs and benefits of a proposed investment. The profitability index, or benefit-cost ratio, is calculated by dividing the present value of the discounted after-tax cash flow by the cost of the investment.
As a general rule, an investment with a profitability index ratio equal to or greater than one is considered a potentially profitable opportunity. In other words, if the present value of the after-tax cash flow is equal to or higher than the cost of the investment, the investment may be worth undertaking from a financial perspective.
What Is After-Tax Cash Flow vs. Discounted After-Tax Cash Flow?
After-tax cash flow is how much cash remains after subtracting operating costs, borrowing costs, and taxes from gross revenue. Discounted after-tax cash flow, on the other hand, incorporates a discount rate to reduce future revenues to their present value.
How Does Depreciation Work in Real Estate?
Owners of an income-producing property, such as an apartment building, are allowed to depreciate, or take a tax deduction for a portion of the property’s value, each year. Depending on which depreciation method they use and how long they have held the property, they can write it off over a 27.5-year, 30-year, or 40-year period. If they sell the property, however, they may be subject to depreciation recapture, in the form of a tax on any profit they make.
What Is the Cost Approach in Real Estate Valuation?
The cost approach in real estate valuation bases the value of a property on what it would cost to build a very similar property, including the price of the land. There are two basic methods that can be used in the cost approach. The reproduction method calculates cost based on replicating the property using similar materials. The replacement method calculates the cost of building a property of similar utility but with new materials and building techniques. Property insurers use a version of the cost approach in setting the premiums for homeowners and commercial insurance policies.
What Is the Sales Comparison Approach (SCA) in Real Estate Valuation?
The sales comparison approach (SCA) in real estate valuation calculates the value of a property based on what comparable properties (referred to as “comps”) in that area have recently sold for. It is commonly used by real estate appraisers and agents in putting a value or setting a price on residential property and is required by some lenders and mortgage underwriters.
What Is the Income Approach in Real Estate Valuation?
The income approach in real estate evaluation is used to set a value on income-producing properties, such as an office building or apartment complex. It’s calculated by dividing the property’s net operating income (NOI) by a capitalization rate, or cap rate.
Net operating income is the rental income produced by the property minus the costs of maintaining it.
The capitalization rate represents the expected return on a particular real estate investment. It is calculated by dividing the property’s net operating income by its current market value.
The Bottom Line
There are several different methods for valuing real estate investments, one of them being discounted after-tax cash flow. Investors should not rely solely on this method to make a decision about a particular property. To examine the property’s value from multiple perspectives, they can also use other methods of real estate valuation, such as the cost approach, sales comparison approach (SCA), and income approach.