DCF, Yield & Reversion
~12 min read · Discount cash flows and reversion, and separate yield rates from cap rates.
Discounted cash flow values a STREAM: project each year's cash flow, sell the property on paper at the end (the reversion), and discount everything to present value at a yield rate. The exam tests the components — and the difference between a cap rate (one year) and a yield rate (the whole ride).
The machinery
DCF projects NOI (or pre-tax cash flow) over a holding period (commonly 5–10 years) with explicit assumptions: rent growth, expense growth, vacancy, rollover costs (tenant improvements, leasing commissions for commercial). Each year's cash flow is discounted at the yield rate (Y, discount rate) — the investor's required TOTAL return; the present values sum with the discounted reversion into value. Every assumption must be market-supported: DCF is only as honest as its inputs.
- Project → terminal sale → discount → sum
- Yield rate = required total return over the holding period
- Assumptions (growth, rollover, vacancy) must trace to market support
The reversion
The reversion is the projected sale at the holding period's end: typically terminal (going-out) cap rate applied to the FOLLOWING year's NOI (year n+1), minus selling costs. Terminal cap rates usually sit ABOVE going-in rates (the building is older; growth priced in has been consumed) — a terminal rate below the going-in rate needs explaining. The reversion often carries a third or more of total present value; small terminal-rate changes move the answer materially.
- Reversion = NOI(n+1) ÷ terminal cap, less selling costs
- Terminal rate ≥ going-in rate, normally
- Discount the reversion like any other future receipt
Cap rate vs yield rate
Ro (cap rate) relates ONE year's income to value — a snapshot ratio embedding growth implicitly. Y (yield/discount rate) is the multi-year total return — explicitly separated from growth. Their kinship: Ro ≈ Y − g (rate ≈ yield minus growth) for stable-growth property; a market with 7% yields and 2% growth trades near 5% caps. Direct cap and DCF answer the same question through different windows and should reconcile.
Worked example
A stabilized retail building: year-1 NOI $200,000 growing 3%/year; 5-year hold; terminal cap 7.5% on year-6 NOI; selling costs 2%; investors require a 9% yield. Sketch the valuation (annual discounting).
Cash flows: 200,000; 206,000; 212,180; 218,545; 225,102. Year-6 NOI: 231,855 → reversion = 231,855 ÷ 0.075 = 3,091,400 × 0.98 (selling costs) = 3,029,572, received at year 5. Discount at 9%: the five NOIs' PV ≈ 200,000/1.09 + … + 225,102/1.09⁵ ≈ 826,000; reversion PV = 3,029,572 ÷ 1.09⁵ = 3,029,572 ÷ 1.5386 ≈ 1,969,000. Value ≈ $2,795,000. Cross-check: Ro ≈ Y − g = 9% − 3% = 6%; direct cap: 200,000 ÷ 0.06 = $3,333,000 — the DCF's lower answer reflects its 7.5% terminal drag; reconciling the spread (is the terminal rate right? the growth?) is exactly the analyst's discussion. The reversion carried ~70% of value — the exam's favorite observation.
Common exam pitfalls
Capitalizing year-5 NOI for the reversion.
The buyer at year 5 buys the NEXT year's income — terminal cap applies to year-6 (n+1) NOI.
Using one rate for both cap and yield.
Ro is a one-year ratio; Y is total return. Ro ≈ Y − g links them — equal only when growth is zero.
Growth assumptions without market support.
Every projection input (growth, rollover, terminal rate) needs survey/extraction support in the workfile.
Project the years, sell on paper at n+1 over terminal, discount it all — and remember: cap is a snapshot, yield is the movie.
Recap
- DCF: projected cash flows + discounted reversion, at the yield rate
- Reversion = year n+1 NOI ÷ terminal cap, less selling costs
- Terminal rates normally exceed going-in rates
- Ro ≈ Y − g connects the two frameworks
- Reversion often dominates present value
- Assumptions live or die on market support
Prove it: 10 questions on this topic
Every lesson ends with a ten-question check in the free course — your progress syncs between the web and the EstatePass app.