Question 1. A big challenge with the NPV is the assumptions on the return and inflation. This is less of an issue if we are buying a $100,000 machine with a 5 year life. Real estate however is a long term investment.
- How do you estimate inflation over 5 years, 10 years and up to 30 years?
- Nobody has a crystal ball and if you estimate inflation staying flat at 2-3%, but it jumps to 8%, it destroys your projections. How do you protect yourself from this?
Question 2. Another challenge we have with the discounted cash flow methods, specifically NPV, is estimating cash flows. In commercial real estate vacancies are hard to predict and can leave a huge gaping wound in cash flow. In this downturn I am sure you have all witnessed some units that have been 50% empty for 3 years or more. I doubt that the investors anticipated that.
- How do you estimate a vacancy risk factor in your cash flow analysis?
- Does sensitivity analysis help with this? If so how?