Discounted Cash Flow (DCF) in Commercial Property

What is Discounted Cash Flow (DCF)?

DCF is a way to estimate what a property is worth right now based on the money it's expected to generate in the future. It's not about what similar properties sold for. It's about what this property will earn, and how much those earnings are worth today.

At the core of DCF is a simple truth: a pound today is worth more than a pound tomorrow. Why? Because today's pound can be invested, spent, or saved, it has opportunity value. That's known as the time value of money, and it's the backbone of DCF.

Here's how DCF works in commercial property investing

You project the property's future cash flows: rental income, resale proceeds, maybe some refurbishment costs, and then you discount each year's total back to present value using a discount rate. Add everything up, and you've got the property's intrinsic value.

This approach also helps investors plan for when to sell commercial property, since projected exit income forms a major part of the asset’s overall value. Understanding discounted cash flow becomes easier once you have a clear sense of how to invest in commercial property and what drives long term value.

Let's say a retail unit generates £100,000 annually for five years. You expect to sell it for £1.2 million in year six. Rather than adding those numbers directly, you discount each future cash flow based on risk, inflation, and opportunity cost. The farther out the cash flow, the less it's worth today.

Here's what that looks like in practice. The table below shows how rental income, costs, and a final sale value are projected and then discounted to present value using a 6% discount rate:

The basic Discounted Cash Flow formula is:

Where:

• CF = cash flow in each year
• r = discount rate (your required return)
• n = year of the cash flow
• Terminal Value = projected value of the asset at exit

Different property types = different cash flow behaviours

Cash flow isn't one size fits all.

• Office buildings may have long leases and stable income
• Retail properties often see fluctuation due to turnover or seasonal performance
• Industrial units might have fewer tenants but longer tenancy terms

DCF captures these nuances better than sales comps or net initial yield. It's particularly useful when you're dealing with irregular lease structures, refurbishment plans, or underperforming assets with upside potential.

DCF gives investors a forward looking decision framework

In uncertain markets, historical comps don't always reflect future reality. That's where DCF earns its keep. It lets you value an asset based on expected performance, not just market sentiment.

Let's say two warehouse investments are priced the same, but one has leases expiring in 6 months while the other is locked in for 10 years. The difference in future income is massive. DCF quantifies that difference.

This makes DCF especially powerful in:

• Value add strategies where NOI is expected to increase
• Distressed asset analysis where future stabilisation matters
• Markets with weak comparables or fluctuating net initial yields

Takeaway:

DCF gives you a tactical lens to evaluate commercial property based on its ability to generate future income. In today's market, where past performance doesn't always predict future value, that forward looking perspective can be a strategic edge.

How do you build a DCF model for commercial real estate?

Start by projecting income, expenses, and resale value, then apply discounting

Building a discounted cash flow model starts with projecting future income and costs. For a commercial property, that means:

• Rental income
• Operating expenses
• Capital expenditures
• Exit proceeds

Then, you discount those future figures to today's value using a rate that reflects the investment's risk.

A solid model includes the full income stream and all deductions, don't just focus on rent. You'll need to factor in business rates, insurance, repairs, and any planned improvements.

Account for lease structures that impact income timing

UK commercial leases often include break clauses, stepped rents, or upward only rent reviews. These can materially affect cash flow timing and risk. A lease with a break option in year 3, for example, shouldn't be treated as guaranteed income through year 10.

Be sure to model events like a scheduled rent review or lease renewal assumptions. If you're modelling a full repairing and insuring lease, remember that net rent may overstate cash flow if you're ignoring void costs or capex.

Time horizons should reflect lease terms, not arbitrary periods

A typical DCF model runs for 5 to 10 years, but that's not a rule. The right horizon depends on the asset. If you're holding an industrial site with a 15 year lease to a national covenant, it may make sense to model the full lease term. For flexible retail units, you may only project 3-5 years and apply a terminal value.

Factor in risks that aren't obvious in the rent roll

It's easy to overestimate value by overlooking voids, weak tenants, or refurbishment downtime. Your model should reflect realistic assumptions, not best case fantasies. For example, if a tenant's covenant is weak or rent is above market, assume shorter tenancy or higher re-letting costs.

Also consider planned capex. If you expect to invest £250,000 in year 2 to upgrade plant or common areas, that outlay should reduce your net cash flow, and affect your return.

How do you calculate terminal value and choose a discount rate?

Use a net initial yield or growth model to estimate terminal value, then build your discount rate from risk and return

Discounted cash flow models don't run forever. Most stop at year 5 or 10, depending on lease profiles and asset type. But property still has value beyond that, and terminal value is how you account for it.

The most common method? Apply the Gordon Growth Model to the final year's cash flow or divide by a NIY.

Bottom line: terminal value isn't a wild guess, it's a snapshot of future worth based on today's assumptions. Get those assumptions wrong, and the rest of your model falls apart.

Don't let your terminal value outpace reality

This is where overly optimistic models unravel. A slight overstatement in your growth rate or an unrealistic exit yield can balloon your valuation. A 3% growth rate paired with a 5% discount rate gives you a perpetuity multiple of 20x. That's aggressive, and risky.

Reality check your assumptions. Cross reference investor sentiment, look at recent transactions, and use reversionary yield benchmarks if you're projecting upside. Terminal value should reflect what the market would actually pay, not just what your spreadsheet wants it to be.

Discount rate = required return + risk

This is the heart of any DCF. Your discount rate reflects both the return you want and the risk you're willing to take. For long let logistics in a strong location, a 5.5-6% rate may be justified. For a high vacancy retail scheme? You might need 9-11% to offset the risk profile.

Start with the risk free rate (gilts), layer in a market risk premium, and then adjust for asset specific risks: lease length, tenant covenant strength, location quality, and asset condition. No shortcuts, build it up systematically or risk skewing the whole model.

Rising rates? Your model should reflect that

If the base rate climbs, your discount rate should move with it. Using yesterday's assumptions in today's market won't cut it, especially if yields on comparable assets are adjusting upward.

Should other metrics be used alongside DCF?

Yes, pair DCF with yield metrics and comps for a fuller valuation picture

While DCF focuses on income, it shouldn't stand alone. Use it alongside yield analysis and comparable sales to get a more accurate sense of market value. For example, compare your DCF result to the commercial property value based on local comps or cross reference against commercial property yields to test your assumptions.

And if you want to push deeper into return metrics, it often pairs well with internal rate of return for project level evaluation.

The table below shows how DCF, NIY, and sales comparables differ in what they measure and how they support investment decisions:

To see how local listings compare in terms of pricing, yield, and lease terms, explore available commercial properties for sale.

Frequently Asked Questions About DCF

How is discounted cash flow different from net initial yield?

NIY is a snapshot based on current income and purchase price, typically used to compare investment properties in the UK. DCF, on the other hand, looks forward, it models how much cash the property will generate over time and adjusts for the time value of money. NIY is simpler but less comprehensive. DCF gives a fuller picture when cash flows are uneven or expected to change.

What's a good discount rate to use in UK commercial property?

It depends on the asset's risk. For prime office or logistics properties with secure leases, discount rates may range from 5% to 6.5%. For higher risk assets like secondary retail or value add plays, 8% to 11% might be more appropriate. Many investors start with the risk free rate (e.g. UK gilts), then add a market risk premium and property specific adjustments for lease length, covenant strength, and location quality.

Is discounted cash flow ever used with negative cash flow properties?

Yes, especially in value add or redevelopment projects. Early year losses can be modelled as negative cash flows, followed by projected gains after stabilisation. DCF is one of the few methods that lets you factor in a turnaround strategy over time. Just make sure your assumptions are realistic and backed by evidence, or the model may overstate value.

When should I use DCF instead of sales comparables?

Use DCF when cash flow potential matters more than recent sales data, for example, if a property has expiring leases, upside from refurbishment, or unusual lease terms. Comparables are helpful, but they reflect past transactions. DCF captures what a specific asset might earn moving forward, which is often more useful in fast-moving or underperforming markets.