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Hello A.CRE:
When modeling Period 0, should cash flow from operations (CFO) be included in this period or would CFO be first recognized in Year 1? I noticed in the Lakefront Industrial modeling exercises Period 0 did not include any operating cash; however, that was an operating asset generating revenue on the day the acquisition would have occurred. Therefore, wouldn’t cash flow be available to be recognized in Period 0 vs. Period 1?
From an IRR perspective, doesn’t it assume that the time delta between Period 0 and Period 1 is (1) year?
Please clarify how you view this and what the industry practices are.
Thank you!
Nick
I regularly see this question arise as a point of confusion for many and so I’m glad you asked this!
First to the answer and then an explanation. There should never be Operating Cash Flow or Reversion Cash Flow in period (i.e. time) zero; only Investment Cash Flows.
The entire concept of time zero comes from the traditional DCF in finance. Imagine you’re investing in a 10,000 bond with a 10% coupon rate. You purchase the bond in time 0, and then in each time that follows you receive a coupon equal to 10% of the bond’s face value. At the bond maturity, you receive the face value of the bond back (i.e. the residual). Thus the bond looks something like:
End of Period 0: -10,000
End of Period 1: 1,000
End of Period 2: 1,000
End of Period 3 (Maturity): 1,000 + 10,000If you run an IRR on the above cash flow, assuming each period is equal to one year, the result is 10.0% which unsurprisingly is equal to the coupon rate. You wouldn’t think to include the coupon in time zero, because you don’t own the bond in period 0 but rather purchase the bond at the end of period 0 and then receive a coupon at the end of each subsequent period.
So it goes with a real estate DCF. In time zero, you purchase the real estate (or in the case of a development you deploy your first dollar). Operating Cash Flow then begins in period 1 and continues until the end of the analysis period, at which point there is a sale (or residual value). The DCF looks very similar:
End of Period 0: Acquisition (Outflow)
End of Period 1: Operating Cash Flow (Inflow)
End of Period 2: Operating Cash Flow (Inflow)
End of Period 3: Operating Cash Flow (Inflow) + Reversion Cash Flow (Inflow)Again, you wouldn’t think to include operating cash flow in period 0 because you don’t own the asset in period 0 but rather purchase the real estate at the end of period 0.
Thanks again for the great question!
Thank you Spencer – This makes complete sense the way you have explained it. My main point of confusion was thinking that Period 0 was a ‘beginning of period concept’ vs. and end of Period (if that makes sense).
I have seen a number of broker packages from high profile types (CBRE etc.) that include operating cash flow in Year 0 in their IRR/Financial Analysis. I know now this just wrong and essentially lets them juice the IRR artificially by including an extra year of operating cash in their hold period. I don’t think they are doing this intentionally but they may not understand the concept fully.
Cheers,
Nick
Nick – Yes I’ve seen this done as well, and that practice overstates the returns and is incorrect. Doing so is no different than pricing a bond by including a coupon payment in the initial period with the bond purchase, which would overstate the bond yield and would thus be incorrect.
Another way to conceptualize the time zero concept is to consider daily periods (I apologize for belaboring the point but there may still be people confused about this). You wouldn’t include operating cash flow on the day the property is purchased, correct? Because you don’t own the operating cash flows until the next day. Thus the DCF would look something like:
Day 0: – Acquisition Cost
Day 1: + Operating Cash Flow
Day 2: + Operating Cash Flow
Day 3: + Operating Cash Flow
Day Etc.: + Operating Cash Flow
Day Reversion: + Operating Cash Flow + Reversion Cash Flow
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