How to Determine the Terminal Value of Commercial Real Estate

by Chirantan Basu; Updated September 26, 2017
Discounted cash flow analysis is based on the principle that a dollar today is worth more than a dollar tomorrow.

Terminal value is the discounted value of all cash flows after the terminal year. This is the year in which the investment period ends. Discounted cash flow is the discounting of future cash flows to the present. Commercial real estate includes office buildings, shopping malls, factories and vacant land. The terminal value is a key component of asset valuation.

Calculate the terminal value by assuming that the property increases in value by a constant annual rate until the terminal year. The terminal value formula is: CV_(1 + r)^t, where CV is the current value of the real estate property, r is the discount rate and t is the terminal year. You can use the current rate of inflation for the discount rate. For example, if the current value is $1,000, the terminal year is 5 and the inflation rate is 2 percent, the terminal value is $1,104.08: 1,000_(1 + 0.02)^5. There are two problems with this approach: First, you're assuming the current value estimate of the commercial real estate property is just right, meaning neither too high nor too low; and second, that there will be steady and constant growth in its value until the terminal year. These assumptions are unlikely to hold over a long period of time. For these reasons, an alternative approach is often used.

Calculate the terminal value by assuming a constant cash flow growth rate into perpetuity, starting in the terminal year. The terminal value formula is: CF/(r - g), where CF is the cash flow generated by the property in the terminal year, g is the constant annual cash flow growth rate, and r is the discount rate. For example, if the cash flow starting in terminal year 5 is $100, the discount rate is 8 percent and the constant annual cash flow growth rate is 2 percent, the terminal value is $1,666.67: 100/(0.08 - 0.02). Note that if you assume a zero constant annual cash flow growth rate (g), then the terminal value formula simplifies to CF/r (cash flow divided by discount rate).

Calculate the present value of the terminal value, which is effectively a one-time future cash flow. The present value formula is TV/(1 + r)^t, where TV is the terminal value in year t, and r is the discount rate. For example, if the terminal value is $1,000 in year 10 and the discount rate is 4 percent, the present value is $675.56: 1,000/(1 + 0.04)^10.

Tips

  • The discount rate for assets is usually the firm's cost of capital (i.e., its cost of borrowing money).

Video of the Day

Brought to you by Techwalla
Brought to you by Techwalla

About the Author

Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.

Photo Credits

  • Jupiterimages/Photos.com/Getty Images
Cite this Article A tool to create a citation to reference this article Cite this Article