When we wrote our series on how Our $50K Duplex Is Now Worth $97K. some readers were wondering why we werent interested in flipping the property and making a quick buck.  Well, what it comes down to is that we think the long term cash flows that were going to get out of the duplex far outweigh the amount that we would have netted if we tried to sell it shortly after we bought it.

What Would A Flip Have Looked Like?

Immediately after we bought the duplex for $50K. we put about $8K into it, got it rented, and then it appraised for $76K (an appraisal I thought was a bit of a stretch).  So if we had sold it then for, say, $70K, we would have been looking at net consideration to us of $70K minus a 6% realtor fee, so about $65.8K.

• Our costs were about $58K
• Would give an overall profit $7.8K
• But after 28% in taxes (short term capital gains are taxed as ordinary income), thats only $5.6K

Thats not chump change at an almost 10% profit in about 5 months, but for the number of hours that we put into the duplex (and the number of cuts and electrocutions), we werent really ready to sell out for minimum wage (or less).

So instead of looking at it as what we could sell the duplex for in the open market, we tend to look at the duplex as what the cash flows will look to us over the usable life of the duplex.  For this, we can use a nifty valuation method called a DCF.

[In case its not obvious, this DCF analysis works for any stream of cash flows, so if instead of real estate you own some internet real estate thats bringing in cash   Im talking to you, other bloggers    this is one way to estimate how much its worth to you today!]

Whats A DCF?

DCF stands for Discounted Cash Flow. and the basic idea behind this analysis is that to understand what future cash flows are worth today. you need to figure out what you would need today to be able to generate that amount of cash at that future date.  I know, it sounds a little confusing at first, but hear me out.

Lets think about first it in terms of what you need today  to generate a specific dollar amount at some fixed time in the future .

For example Lets say you want an investment to be worth $5,000 3 years from now.  You are reasonably confident that you can generate a safe return of 5% over the next three years.  (5% is an example, lets not get into interest rates on cds here)

To find out how much we need to start with, all we need to do is solve for X in the equation:

Thinking back to math class, we can solve this and see that $X = $4,319.19.  So if we feel confident that we can get a 5% return over the next 3 years, we would only need to invest $4,319.19 today to have that $5,000 when we need it .

But the DCF goes the other way around, right?  If we know our investment will throw off $5,000 in cash 3 years from now what is that investment worth to us today?

In reality, this is the same problem that we solved in the example above, except no one has told us what percent return we think we could generate over the next 3 years.  The example above, we assumed 5%, but this rate is something that we actually get to think about and choose for ourselves, and its called the discount rate .

So how did we solve for $X above?  We calculated:

which is actually this formula:

But that was only for one year worth of returns three years in the future, so to calculate what ALL of the cash flow is worth over a period of many years, we calculate each year separately and add them up.  For short-hand in this formula, = cash flow in year 1, = cash flow in year 2, etc and = discount rate.  So the discounted cash flow, or DCF, is just:

where is however many years forward youre projecting.

The IRS lets you depreciate an investment property over 27 years, so I tend to take my DCFs out to n=27, and assume the property is used-up, with no value at that time.  (Not really accurate in real life, but since thats the way the tax-man looks at it and its an underestimate of value it works for us.)

DCF Step 1: Calculate Your Yearly Cash Flows

With any investment property, you should have a pretty good idea where your money is coming from and going to.  So we have a spreadsheet set up that looks something like this.  This table is a version of an Excel table that we used to calculate estimated yearly cash returns the values are in $ thousands.