Part 1: Real Estate Income Analysis

An income property may look very attractive as an investment at first glance. Cash flow and property value are produced by numerous variables, and changes to any one variable can easily change the whole equation. Cash flow and property value are sensitive to change.

As a sophisticated real estate investor, you find an 80%-occupied, 20-suite office commercial building for sale, priced at $2.5 million. You are given a professional package of brochures, which presents the property attractively. You focus on the pro forma of the building, which is given over a ten-year period. You also notice in the brochures that the seller has used a discount rate and a terminal capitalization rate to value the sale price of the property.

What risks do you foresee in purchasing this property? What measures would you take to manage these risks? Will these risks affect the price that you would offer? If so, how would they affect your pricing decision? If not, what factors would contribute to your pricing decision?

Part 2: Discounted Cash Flow Analysis

In the discounted cash flow method, the discounted and terminal capitalization rates are often applied to cash flows over a period of five to ten years in income-producing real estate valuation. In addition, for sensitivity financial analysis, the income and expense items are also projected over the same period based on different scenarios, which, in turn, change the real estate valuation.

What are the pros and cons of using such an approach to justify your application for a loan from a lender to fund your real estate project? How would you improve such an approach in order to increase your possibility of securing the loan?