Transcript Chapter 11:

Chapter 11:
Real Estate Cash Flow Pro Formas &
Opportunity Cost of Capital (OCC)
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1
"PROFORMA"
= a multi-year cash flow forecast
(Typically 10 years.)
Show to: Lenders, Investors
But the proforma can be more useful than just “window
dressing”, if done properly.
It is the basic vehicle to implement the DCF valuation and
analysis procedure discussed in the previous chapter.
The CF proforma presents the numerators in the RHS of the
DCF valuation equation.
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2
Uses of multi-year DCF analysis in real estate…

Estimate market value of assets


Estimate “investment value” of assets



Explore upside, downside plausible ranges
“Underwriting” for debt finance (sometimes deliberately
conservative CF projections)
Ex ante performance attribution


CF projections should be unbiased mean subject investor
effects (we’ll discuss in Ch.12)
Sensitivity analysis & “crash testing” (What if?)


CF projections should be unbiased mean mkt expctns
For investment strategic decision making
Ex post analysis for diagnostics

Performance attribution for investment management,
internal accountability mgt.
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3
2 types of CFs:
•
Operating
•
Reversion (Sale of Property, Sometimes
partial sales)
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4
2 ways of defining "bottom line". . .
1) Property level (PBTCF, most common in practice):
 Net CF produced by property, before subtracting debt svc pmts (DS) and
inc. taxes.
 CFs to Govt, Debt investors (mortgagees), equity owners.
 CFs due purely to underlying productive physical asset, not based on
financing or income tax effects.
 Relatively easy to observe empirically.
 Focus of Chapter 11.
2) Equity ownership after-tax level (EATCF):
 Net CF avail. to equity owner after DS & taxes.
 Determines value of equity only (not value to lenders).
 Sensitive to financing and income tax effects.
 Usually difficult to observe empirically (differs across investors).
 Will be addressed in Chapter 14.
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5
Typical proforma line items...
Exhibit 11-1:
At Property, Before-tax Level:
Operating (all years):
Potential Gross Income = (Rent*SF)
- Vacancy Allowance = -(vac.rate)*(PGI)
+ Other Income = (eg, parking, laundry)
- Operating Expenses
_____________________
Net Operating Income
- Capital Improvement Expenditures
_____________________
Property Before-tax Cash Flow
= PGI
=
- v
= +OI
= - OE
_______
= NOI
=
- CI
_______
= PBTCF
Reversion (last year & yrs of partial sales only):
Property Value at time of sale
- Selling Expenses = -(eg, broker)
__________________
Property Before-tax Cash Flow
=
V
= - SE
______
= PBTCF
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6
Questions…
How forecast vacancy (v)?
• Vac = (vac months)/(vac months + rented months) in typical cycle.
• Look at typical vac rate in rental mkt; adjust for non-stabilized bldgs (e.g.,
gross vacancy in mkt typically > typical stabilized vac).
• History of vac. in subject bldg.
• Project for each space/lease: Probability of renewal & Expected vacant period
if not renewed.
How forecast resale value (“reversion”, V at end)?
• Divide Yr.11 NOI by “going-out” (terminal) cap rate.
What should be the typical relationship between the
going-in cap rate and the going-out cap rate?. . .
• Usually going-out  going-in (older bldgs have less growth & more risk), esp. if
little capital imprvmt expdtrs have been projected.
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7
Exhibit 11-2: NCREIF Same-Property NOI Growth vs Inflation:
4.0
1979-2011
Gray shade
indicates GDP
recession
3.5
1978Q4 = 1.0
3.0
2.5
2.0
1.5
1.0
0.5
NCREIF NOI
CPI
NOI gro avg = 3.0%/yr, Infla avg = 3.8%/yr. NOI is gross of CapEx averaging 31% of NOI. (Source: NCREIF)
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8
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
0.0
Exhibit 11-3: Average Reported Vacancy Among NCREIF
Properties: 1983-2011
15.0%
12.5%
10.0%
7.5%
5.0%
Gray shade
indicates GDP
recession
2.5%
0.0%
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
(Source: NCREIF)
Vacancy tends to be cyclical
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9
Exhibit 11-2: As New Competitors Enter the Market, Spread Between Building and
Submarket Vacancy Increases for Older Buildings
(Source: Torto-Wheaton Research; “TWR Overview &Outlook”, Winter 2004.)
Basis Point Spread
400
300
200
100
0
-100
-200
-300
-400
-500
Mid 70s vintage
2003.3
2002.4
2002.1
2001.2
2000.3
1999.4
1999.1
1998.2
1997.3
1996.4
1996.1
1995.2
1994.3
1993.4
1993.1
1992.2
1991.3
1990.4
1990.1
1989.2
1988.3
1987.4
-600
Early 80s vintage
Vacancy tends to increase as buildings age
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10
11.1.3. Operating Expenses
include:
Fixed:
 Property Taxes
 Property Insurance
 Security
 Management
Variable:
 Maintenance & Repairs
 Utilities (not paid by tenants)
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11
Operating Expenses
NOTE:
OE do NOT include:
 Income taxes,
 Depreciation expense.
Must include mgt expense even if self-managed.
Why? . . .
Opportunity cost, “apples-to-apples” comparison with
alternative investments that you don’t have to manage yourself.
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12
Capital Expenditures
include:
Leasing costs:
 Tenant build-outs or improvement
expenditures (“TIs”)
 Leasing commissions to brokers
Property Improvements:
 Major repairs
 Replacement of major equipment
 Major remodeling of building, ground &
fixtures
 Expansion of rentable area
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13
Two truths often not reflected in proformas used in
practice in the real world . . .
• Realistic long-term rental growth projections in
most commercial properties in most areas of the
U.S. should average slightly less than realistic
expectations about general (CPI) inflation.
• Realistic long-term capital expenditure
projections for most types of commercial
property should average at least 10% to 20% of
the NOI, or an annual average of about 1% to 2%
of the property value.
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14
Simple numerical example (in Appendix 11A: Exh.11A-1)
Exhibit 11-2: The Noname Building: Cash Flow Projection
Year:
1
2
Item:
Market Rent/SF:
$10.00
$10.10
Potential Revenue:
Gross Rent Space 1 (10000SF)
$105,000 $105,000
Gross Rent Space 2 (10000SF)
$100,000 $100,000
Gross Rent Space 3 (10000SF)
$100,000 $101,000
Total PGI
$305,000 $306,000
Vacancy allowance:
Space 1
$0
$0
Space 2
$0
$0
Space 3
$100,000
$0
Total vacancy allowance
$100,000
$0
Total EGI
$205,000 $306,000
Other Income
$30,000
$30,300
Expense Reimbursements
Space 1
$0
$1,833
Space 2
$0
$2,944
Space 3
$0
$0
Total Revenue
$235,000 $341,078
Reimbursable Operating
Expenses
Property Taxes
$35,000
$35,000
Insurance
$5,000
$5,000
Utilities
$16,667
$25,500
Total Reimbursable Expenses
$56,667
$65,500
Management Expense
$6,150
$9,180
Total Operating Expenses
$62,817
$74,680
NOI
Capital Expenditures
TI
Leasing Commissions
Common physical
improvements
$172,183
Net Cash Flow (operations)
Net Cash Flow (reversion)
IRR @ $2,000,000 price: 10.51%
$172,183
$266,398
3
4
5
6
7
8
9
10
11
$10.20
$10.30
$10.41
$10.51
$10.62
$10.72
$10.83
$10.94
$11.05
$105,000
$100,000
$101,000
$306,000
$103,030
$100,000
$101,000
$304,030
$103,030
$100,000
$101,000
$304,030
$103,030
$105,101
$101,000
$309,131
$103,030
$105,101
$106,152
$314,283
$103,030
$105,101
$106,152
$314,283
$108,286
$105,101
$106,152
$319,539
$108,286
$105,101
$106,152
$319,539
$108,286
$110,462
$106,152
$324,900
$0
$0
$0
$0
$306,000
$30,603
$51,515
$0
$0
$51,515
$252,515
$30,909
$0
$0
$0
$0
$304,030
$31,218
$0
$52,551
$0
$52,551
$256,581
$31,530
$0
$0
$53,076
$53,076
$261,207
$31,846
$0
$0
$0
$0
$314,283
$32,164
$54,143
$0
$0
$54,143
$265,396
$32,486
$0
$0
$0
$0
$319,539
$32,811
$0
$55,231
$0
$55,231
$269,669
$33,139
$2,003
$3,114
$170
$341,891
$0
$1,814
$0
$285,238
$1,651
$3,465
$260
$340,624
$964
$0
$0
$289,075
$1,118
$153
$0
$294,324
$2,870
$1,905
$1,752
$352,974
$0
$469
$316
$298,667
$1,823
$2,292
$2,139
$358,602
$329
$0
$645
$303,781
$35,000
$5,000
$26,010
$66,010
$9,180
$75,190
$35,000
$5,000
$22,109
$62,109
$7,575
$69,684
$35,000
$5,000
$27,061
$67,061
$9,121
$76,182
$36,750
$5,250
$23,002
$65,002
$7,697
$72,699
$36,750
$5,250
$23,462
$65,462
$7,836
$73,298
$36,750
$5,250
$28,717
$70,717
$9,428
$80,146
$36,750
$5,250
$24,410
$66,410
$7,962
$74,371
$36,750
$5,250
$29,877
$71,877
$9,586
$81,463
$36,750
$5,250
$25,396
$67,396
$8,090
$75,486
$266,701
$215,554
$264,442
$216,376
$221,026
$272,828
$224,295
$277,139
$228,295
$55,000
$15,765
$55,000
$15,923
$145,611
$150,103
$50,000
$15,150
$50,000
$15,455
$55,000
$16,243
$55,000
$16,569
$100,000
$201,248
$266,701
$150,100
$164,442
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$272,828
$153,053
$277,139
$2,282,951
15
Section 11.2:
“Opportunity Cost of Capital” (OCC) at the
Property Level
or:
WHERE DO DISCOUNT RATES COME
FROM?...
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16
Broad Answer:
THE CAPITAL MARKETS
That is, competing investment opportunities.
(This is so, whether we are talking about IV
or MV.)
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IN DCF APPLICATIONS, KEEP IN MIND WHAT
THE DISCOUNT RATE IS...
Disc. Rate = Required Return
= Oppty. Cost of Capital
= Expected total return
=r
= rf + RP
= y + g,
among investors in the market today
for assets similar in risk to the property in
question.
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18
11.2.3 Historical Evidence about R.E. OCC in the U.S.
Exhibit 11-4(updated): Historical return, risk,
and risk premia, 1970-2010
Total
Risk
Asset Class
Return* Volatility
Premium
T Bills
5.60%
3.10%
NA
G Bonds
9.26%
11.73%
3.66%
Real Estate
10.15%
10.86%
4.55%
Stocks
11.56%
17.91%
5.96%
Source: NCREIF, MIT, Ibbotson. *Arithmetic mean
But this particular 41-yr period may be abnormally favorable ex post
for bonds & RE, and unfavorable for stocks.
Traditionally large-cap stock ex ante RP considered to be ≈ 600-800
bps; LTGovt Bonds ≈ 100-200 bps; Institutional RE 300-400 bps.
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19
11.2.4 Survey Evidence about R.E. OCC in the U.S.
14%
Exh.11-6 Backward-Looking vs Forward-Looking Total Returns in the U.S.
Institutional Property Market: NCREIF vs PwC
What to make of the
difference between
the blue and the
purple lines?...
12%
10%
8%
6%
4%
Perhaps a little
tinting in the
shades?...
2%
0%
2010
2009
2008
2007
2006
NCREIF(Hist)*
2005
2004
2003
LT Bond Yld
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
Inflation
PwC IRR
*Trailing NCREIF average annual total return since 1977.
Survey avg  100-200 bps > Hist.avg.
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20
Exh.11-7 StatedGoing-in IRRs, Cap Rates, & Inflation
14%
12%
10%
8%
6%
4%
2%
0%
2010
2009
2008
2007
2006
PwC Caprate
2005
2004
2003
2002
2001
Inflation
2000
1999
1998
1997
1996
1995
1994
1993
1992
IRR - OAR
PwC IRR
“OAR” = “cap rate”, “CI” = capex rate = Avg ann. capital expenditures as fraction of property value
IRR – OAR = (y+g) – (y+CI) = (y+Infl-Depr) – (y+CI) = Infl – Depr – CI
The brown (IRR-OAR) line should be below the green (infla) line!
(probably at least 200-300 bps below…)
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21
11.2.5
realistic
How to "back out" implied discount rates from "cap rates"
^
(OAR) observed from transaction
prices in the property
market...
Cap rate
e.g.: Data from Real Capital
= NOI / V
Analytics, CoStar, Reis, etc.
= (CF+CI) / V
= y + CI / V = r + CI / V – g
Therefore, from market transaction data...
1) Observe prices (V)
2) Observe NOI of sold properties.
3) Therefore, observe "cap rates" = NOI / V.
4) Compute: r = cap rate – CI / V + g.
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22
Build up the mkt’s implied OCC (IRR)…
IRR = y + g = (caprate – CI) + (Infl – Depr)
Typically:
IRR = (caprate – 100-200 bps) + (Infl – 100-200 bps)
IRR = caprate + Infla – 200-400 bps
These days (for “institutional”), 
IRR  caprate. (Assuming infl approx 3%)
(Shh!... IRR could even be a bit < caprate!... If low
inflation.
But watch out: It can vary over time (e.g., infl, RE mkt),
and across differ types of RE mkts (e.g.
“institutional” vs “mom&pop”, Class-A vs Class-B,
etc)
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23
11.2.6
Double Checking: Two Perspectives on the OCC Estimate
Take the r = rf + RP approach (2006 peak) . . .
• For typical 10 yr horizon investment (2006):
• rf = Expected average short-term T-Bill yield over life of
R.E. investment, well approximated by 10 yr T-Bond yld –
100 bps (“yield curve effect”). (Bond mkt’s expectation of avg
future short-term T-Bill yields over the next 10 years.)
• e.g., if T-Bond yld = 5%, then rf = T-Bond yld – 150 bps =
5% - 1.5% = 3.5%.
• RP = 250 to 400 bps for “institutional” investment property
(based on NCREIF historical avg, ≈ ½ Stk Mkt
RP),  OCC = 3.5% + (2.5%-4%) = 6%-7.5% (or so);
• RP = 500 to 700 bps for “non-institutional” investment
property (smaller, higher risk, less liquid),  OCC = 8% 11%.
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11.2.6
Double Checking: Two Perspectives on the OCC Estimate
Take the r = y + g approach (2006 peak) . . .
• y = “cap rate” (less CapEx) = e.g., in 2006 in the U.S. this
was about 4 to 6% for “institutional” investment property,
more like 6% - 9% for “non-institutional” investment
property.
• Realistic growth rate g = Historical rental mkt growth rate –
Historical inflation + Realistic projected future inflation (Bond
mkt T-Bond yld – Infla-adjusted T-Bond yld “TIP”) –
Property real depreciation rate (≈ 1%- 2%/yr)
• Typically g = 0% to 2% in most markets.
Note disconnect with
equilibrium rf + RP model
•  r = y + g = e.g., in 2006 in U.S. ≈ 4% to 7%
“institutional”, 6% to 11% “non-institutional”.
(Remember: This is meant to be applied to property-level CFs.)
If y + g model below rf + RP model  Current pricing is “high.”
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11.2.6
Double Checking: Two Perspectives on the OCC Estimate
Take the r = rf + RP approach (today). . .
• For typical 10 yr horizon investment (today):
• rf = Expected average short-term T-Bill yield over life of
R.E. investment, well approximated by 10 yr T-Bond yld –
100 bps (“yield curve effect”). (Bond mkt’s expectation of avg
future short-term T-Bill yields over the next 10 years.)
• e.g., if T-Bond yld = 2%, then rf = T-Bond yld – 150 bps =
But these seem too low…
2% - 1.5% = 0.5%.
• RP = 350 to 450 bps for “institutional” investment property
(based on NCREIF historical avg, ≈ ½ Stk Mkt
RP),  OCC = 0.5% + (3.5%-4.5%) = 4%-5% (or so);
• RP = 500 to 700 bps for “non-institutional” investment
property (smaller, higher risk, less liquid),  OCC = 5.5% 7%.
May reflect Fed intervention (“QE”)
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11.2.6
Double Checking: Two Perspectives on the OCC Estimate
Take the r = y + g approach (today) . . .
• y = “cap rate” (less CapEx) = e.g., today in the U.S. this is
about 6% - 8% for “institutional” investment property, more
like 8% - 10% for “non-institutional” investment property
(non-distressed).
• Realistic growth rate g = Historical rental mkt growth rate –
Historical inflation + Realistic projected future inflation (Bond
mkt T-Bond yld – Infla-adjusted T-Bond yld “TIP”) –
Property real depreciation rate (≈ 1%- 2%/yr)
• Typically g = 0% to 2% in most markets.
Note disconnect with
equilibrium rf + RP model
•  r = y + g ≈ 6% to 10% “institutional”, 8% to 12% “noninstitutional”.
(Remember: This is meant to be applied to property-level CFs.)
If y + g model above rf + RP model  Current pricing is “low.”
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Watch out for terminology:
In Brealey-Myers “capitalization rate” is
often used to refer to “r”, the total cost of
capital (especially in corporate finance).
“r” is also sometimes called the “total
yield” (especially in the appraisal
profession).
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28
Typical per annum OCC (“going-in IRR”) rates
(late 1990s) . . .
For high quality ("class A", "institutional quality")
income property:

10% - 12%, stated.

8% - 10%, realistic.
Lower quality or more risky income property (e.g.,
hotels, class B commercial, turnarounds, "mom &
pops"):

12% - 15%
Raw land (speculation):

15% - 30%
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Typical per annum OCC (“going-in IRR”) rates
(circa 2005) . . .
For high quality ("class A", "institutional quality")
income property:

7% - 9%, stated.

5% - 7%, realistic.
Lower quality or more risky income property (e.g.,
hotels, class B commercial, turnarounds, "mom &
pops"):

8% - 10%
Raw land (speculation):

12% - 25%
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30
Typical per annum OCC (“going-in IRR”) rates
(circa 2011) . . .
For high quality ("class A", "institutional quality")
income property:

8% - 10%, stated.

6% - 8%, realistic.
Lower quality or more risky income property (e.g.,
hotels, class B commercial, turnarounds, distressed
assets, "mom & pops"):

8% - 12% , realistic
Raw land (speculation):

20% - 40%
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31
11.2.6 Variation in Return Expectations Across Property Types
Exh.11-8a: Investor Total Return Expectations (IRR) for Various Property
Types*
14%
12%
10%
8%
6%
4%
2%
Manh Off
Chicago Off.
Suburb.Off
Apts
Indust.
Strip Ctrs
Malls
0%
*Source: PwC Real Estate Investor Survey,2ndt quarter 2011
Malls Strip Ctrs Indust.
Institutional
9.69%
8.97%
8.76%
Chicago
Apts Suburb.Off
Manh Off
Off.
8.78% 9.11% 9.55% 7.81%
Non-institutional 11.61% 11.32% 11.59% 10.98% 10.40% 12.43%
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9.44%
32
Exh.11-8b: Investor Cap Rate Expectations for Various Property Types*
12%
10%
8%
6%
4%
2%
Manh Off
Chicago Off.
Suburb.Off
Apts
Indust.
Strip Ctrs
Malls
0%
*Source: PwC Rea Estate Investor Survey, 2nd quarter 2011
7.50%
7.40%
7.76%
Chicago
Suburb.Off
Manh Off
Off.
6.29%
8.04%
8.33%
6.00%
Non-institutional 10.29%
9.90%
10.18%
7.99%
Malls Strip Ctrs Indust.
Institutional
Apts
9.58%
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10.50%
8.13%
33
Note that the difference in OCC tends to be
much greater between “instituional” vs “noninstitutional” quality real estate (100-300bps),
than between most usage types of property
(office, retail, industrial, residential) within
either of those two categories.
Why do you suppose this is? . . .
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34
“Institutional” (aka “Investment Grade”) properties (larger, in primary mkts) exhibit
different price behavior than smaller (“mom & pop”) properties, as seen in CCRSI…
CoStar CCRSI, Investment vs General Commercial Properties:
Same-property (repeat-sales) Prices, 2000-2012
220
CCRSI General Property
210
CCRSI Investment Property
200
190
1999 Value = 100
180
170
160
150
140
130
2001-10:
General
Investment
All
120
110
RS obs
70%
30%
100%
RS $vol
21%
79%
100%
12/1/2011
6/1/2011
12/1/2010
6/1/2010
12/1/2009
6/1/2009
12/1/2008
6/1/2008
12/1/2007
6/1/2007
12/1/2006
6/1/2006
12/1/2005
6/1/2005
12/1/2004
6/1/2004
12/1/2003
6/1/2003
12/1/2002
6/1/2002
12/1/2001
6/1/2001
12/1/2000
6/1/2000
12/1/1999
100
Data source: CoStar Group Inc. Index values as of June 2012.
Reflects different sources of financing (non-bank vs bank), different owner/investor
clienteles (natl/intl instns vs local/users), different asset mkt segments.
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IN DCF APPLICATIONS, KEEP IN MIND WHAT
THE DISCOUNT RATE IS...
Disc. Rate = Required Return
= Oppty. Cost of Capital
= Expected total return
=r
= rf + RP
= y + g,
among investors in the market today
for assets similar in risk to the property in
question.
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36