Cash flow growth is a key determinant of your projected returns. Forecasting cash flow growth is a highly problematic, albeit essential, component of valuing a property. Of course, the internal rate of return of your investment analysis reflects this growth, as all future cash flows are discounted to reflect their present value.
Digressing into academia for a moment, the Gordon Growth Model (GGM) is a variant of the discounted cash flow model. The GGM assumes that an asset pays a dividend that has a current value of ‘D’ that grows at a constant rate of “G.” The formula is: Price = Dividend / (Rate - Growth).
What the nearby table shows us is that if your property requires a 10% dividend yield and has 0% growth, your required equity valuation is $10. Alternatively, if your expected growth rate of the dividend is 4% in perpetuity, you equity valuation is $16.70. Say you project the two dividend streams for 10 years and utilize the GDM yield to calculate a terminal value. The result is that the IRRs of both scenarios are equivalent.
Thus, if your potential acquisition has sustainable and probable annual cash flow growth, perhaps due to bumps in rent specified by in place leases or prospects for increased occupancy, then a lower initial yield can be justified.
Baseball legend Casey Stengel said, “Never make predictions, especially about the future.” You are paid the big bucks because investment valuations are based on the present value of future cash flows and you have to be prophetic. That being said, you should never pay the seller for upside that is likely to result primarily due to your particular expertise in managing, repositioning, or redeveloping the asset.
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BTW: Attention NYC real estate Dead Heads – of which they are many – the Lead Heads are playing two sets at The Bitter End on Saturday, November 19th. The band, which played live on the Sirius Grateful Dead channel hosted by David Gans, has my son Corby as the lead “Jerry” guitarist. Yes, I got lucky that he likes the GD and not Lady Gaga! Please join us!! These guys are for real!! Show information and videos available at www.LeadHeads.Net.
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