How do you apply DCF analysis to value a commercial real estate investment at CFA Level II?

CFA Level II real estate valuation builds on the Level I cap rate approach by introducing full DCF analysis with explicit cash flow projections.

Step-by-Step DCF for Real Estate:

1. Project Net Operating Income (NOI) Year by Year:

Cedarpoint Capital evaluates Westbrook Office Tower:

Year	Gross Rent	Vacancy	EGI	OpEx	NOI
1	$5.0M	8%	$4.60M	$1.84M	$2.76M
2	$5.15M	7%	$4.79M	$1.89M	$2.90M
3	$5.30M	6%	$4.98M	$1.95M	$3.03M
4	$5.46M	6%	$5.13M	$2.01M	$3.12M
5	$5.63M	5%	$5.35M	$2.07M	$3.28M

Assumptions: 3% annual rent growth, declining vacancy as the building stabilizes, operating expenses at 40% of EGI.

2. Calculate Terminal Value: At the end of the projection period, estimate the property's sale price using a terminal cap rate applied to the next year's NOI:

Terminal Value = NOI_Year6 / Terminal Cap Rate

If Year 6 NOI is $3.38M and the terminal cap rate is 6.5Terminal Value =$3.38M / 0.065 = $52.0M

3. Determine the Discount Rate: For real estate, the discount rate reflects:

• Risk-free rate + Property risk premium
• Typically 7-12% for commercial real estate (depending on property type and quality)
• Often derived from comparable transaction IRRs

Using a 9% discount rate:

Year	Cash Flow	PV Factor	Present Value
1	$2.76M	0.9174	$2.53M
2	$2.90M	0.8417	$2.44M
3	$3.03M	0.7722	$2.34M
4	$3.12M	0.7084	$2.21M
5	$3.28M +$52.0M	0.6499	$35.92M
Total PV			$45.44M

If the asking price is $43M, the NPV is +$2.44M, suggesting a buy.

Terminal Cap Rate vs. Going-In Cap Rate:

• Going-in cap rate: Year 1 NOI / Purchase price (initial yield)
• Terminal cap rate: Applied to projected future NOI for exit valuation
• Terminal cap rate is typically higher than going-in cap rate to reflect the property being older at exit

Exam tip: CFA Level II commonly provides annual NOI projections, a terminal cap rate, and a discount rate, then asks for property value. Don't forget to add the terminal value to the final year's NOI before discounting. Also be prepared to discuss why the terminal cap rate might differ from the going-in cap rate.

For more real estate valuation practice, check our CFA Level II question bank on AcadiFi.