Buy-to-Let Discounted Cashflow

There are a number of measures of investment performance that use discounted cash flow, in which a discount factor takes account of the costs of carrying debt.
These are recognised in all sectors of finance, and can be used to compare the value of a wide range of investments.
The two most important measures are Net Present Value (NPV) and Internal Rate of Return (IRR). Both are provided as financial functions in Excel. They are applied to a future cash flow to indicate what it is worth today. But what do they mean?

How much is a promise of £1,000 in ten years time worth today? The simple answer is to judge how much money would have to be invested today to gross up to £1,000 in ten years time at compound interest.

This will depend on a judgement of interest rates over the whole of the ten year period. The rate used for this is called the ‘discount factor’. The discount factors in a buy-to-let appraisal should reflect the market view of long term interest rates on borrowing across the private rental sector over the period of investment, to which you might choose to add a margin for risk.

With a discount rate (D) of 5.0%, £1,000 (P) in ten years time (N) would be worth:
P /(1+ D)N = £1,000 / 1.0510 = £614

So the £1,000 in ten years time is worth only a little over half as much today. We can say that the ‘present value’ of a £1,000 payment due in ten years time is £614.

We can also say that the ‘annual rate of return’ if we paid £614 now in exchange for a payment of £1,000 in ten years time would be 5%.
If £614 was invested in a bank account that paid 5% interest (ie at 5% APR) credited to the balance each year, it would show a bank balance of £1,000 after ten years.

For those unfamiliar with this kind of maths, it might be a good idea to draw up a little table of the ten year cash flow, starting with £614, and adding interest on it at 5% (ie 0.05 x £614 = £30.70) , making the closing balance at the end of the first year 614 + 30.70 = 644.70. Repeat this for ten years, applying 5% interest to the closing balance of the previous year. After ten years the closing balance will be £1,000. The formula above is just a quicker way of doing the calculation.

Both the NPV, and the Internal Rate of Return (IRR) are based on a forecast of the cash payments and receipts on an investment over the discount period. These costs and receipts are inflated to show how they are expected to increase each year.
Instead of using the NPV function in Excel to get the Net Present Value, each payment in the cash flow could be converted to it’s present value using the formula above, and summed, to give the same result.

Calculating the IRR on a cash flow is not quite so simple. It has to be found by using ‘trial and error’, changing the the discount rate to find a value that would make NPV of the cash flow equal to the money invested. It is much easier to use the IRR function in Excel.

Most financial appraisals compare the investment required by a project with the net rent and any other income available to repay it.
Net rent is the money left from the rent each year after deducting operating costs: management, maintenance, repairs, losses on voids and bad debts, and any losses where service costs exceed charges. It is the money available from the rent to service a loan. In our example, the net rent each year is shown in the seventh column of the cash flow

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