Owner education · Chicagoland commercial and industrial
DCF explained for commercial real estate owners
A discounted cash flow model asks what future property cash receipts and costs are worth today. It is especially useful when an industrial lease expires during the hold, capital work is uneven, or a stabilized cap-rate snapshot hides the work required.
How do you build a property cash-flow projection?
Choose a valuation date and hold period. Build each tenant's contractual rent, options and expiration schedule first. Show expense recoveries, taxes, insurance, repairs and management separately. At rollover, model retention or vacancy, downtime, free rent, new rent evidence, tenant improvements (TI) and leasing commissions (LC). Do not take vacancy twice by reducing occupied rent and adding the same loss again.
Property cash flow is not simply NOI. Subtract capital replacements and leasing outlays, account for their timing, and state how reserves are handled. For a 10,000-100,000-SF building, one tenant departure or roof project can dominate a year's result. Use the condition report and lease abstracts, not a universal rent-growth percentage.
Show an unlevered case before financing. For an equity case, add loan proceeds to the acquisition funding, subtract debt service during the hold, and deduct loan payoff and finance charges at sale. The discount rate and return label must match those cash flows. Pre-tax and after-tax are also different models.
Discount rate versus cap rate: what is the difference?
The discount rate is the assumed required return used to translate future cash into today's dollars. A cap rate divides one year's income by value. An exit cap rate is a specific future resale assumption, commonly applied to the next year's stabilized NOI at the end of the hold. They are not interchangeable or automatically equal.
For an end-of-year cash flow, present value = cash flow / (1 + discount rate)year. Net present value (NPV) subtracts the initial investment from the sum of discounted receipts. A positive NPV means the modeled investment exceeds the chosen return requirement on those assumptions, not that the outcome is certain.
IRR is a rate that makes NPV zero. Nonconventional cash flows with later negative outlays can have multiple IRRs or no useful IRR; dated cash flows also differ from simple annual periods. NPV, capital required and downside exposure should remain visible even when an IRR looks attractive.
DCF worked example: operating cash, reversion and present value
Illustration only, not market data, an appraisal or an investment recommendation. Assume a three-year unlevered hold, end-of-year cash receipts, no income taxes, and an 8% illustrative discount rate.
| Year | NOI | Capital / TI / LC | Operating cash |
|---|---|---|---|
| 1 | $200,000 | $50,000 | $150,000 |
| 2 | $210,000 | $30,000 | $180,000 |
| 3 | $220,000 | $30,000 | $190,000 |
Assume year-4 NOI of $230,000 and a 7% exit cap. Gross reversion at the end of year 3 is $230,000 / 0.07 = $3,285,714.29. With assumed sale costs of 2%, net reversion is $3,220,000. Year-3 total cash is therefore $3,410,000, including the $190,000 operating cash; year-4 NOI is used only to price the sale, not received again in this hold.
Present value = $150,000 / 1.08 + $180,000 / 1.082 + $3,410,000 / 1.083 = $3,000,177.82. At a $3,000,000 all-in initial investment, NPV is $177.82. At a $3,100,000 investment, NPV is negative $99,822.18. These results depend entirely on the assumptions and cash timing.
How do exit cap, rent and downtime change the result?
Keep year-4 NOI at $230,000 and change the illustrative exit cap: at 6%, gross resale is $3,833,333; at 7%, $3,285,714; at 8%, $2,875,000, rounded to dollars before sale costs. Higher exit cap means lower resale at the same income. None of these rates is a Chicago market claim.
Run a matrix of discount and exit rates, then a separate operational downside: lower collected rent, higher tax and insurance costs, longer downtime, larger TI/LC, capital overruns and a delayed sale. Avoid treating rent growth and a lower exit cap as independently guaranteed benefits. Include refinancing maturity in a levered case and show additional equity required, not just a revised return.
Direct capitalization remains a useful NOI/cap-rate snapshot for stabilized income. DCF makes changes and execution costs explicit, but more model detail does not make speculative assumptions reliable. Have an appraiser and financial/tax advisers review property-specific inputs and conventions.
Owner questions and answers
Is the discount rate the same as the cap rate?
No. A discount rate values a series of future cash flows; a cap rate relates one year of NOI to value. An exit cap rate is a future resale assumption.
Does a high IRR prove a good real estate investment?
No. IRR depends on cash timing and assumptions, can be misleading for nonconventional cash flows, and does not measure absolute capital at risk. Review NPV, required equity and downside cases.
Should DCF include mortgage payments?
Include debt service and loan payoff in a levered equity model, not in an unlevered property model. Match the discount rate to the cash-flow basis.
Primary sources and scope
Official references checked 2026-10-06. Program terms, policy contracts, laws and local deadlines can change; use the linked office's current documents before acting. Examples on this page are educational assumptions, not local market data.