I may not have been as clear as I hoped to be. I said...
a relatively simple problem like determining the present value of the future energy-expense savings the photo-voltaic system is forecast to achieve.
And you ask
based on the specific electric company continuing to buy solar generated electricity from the homeowner, which in many cases, electric companies have opted to dramatically reduce what they were paying (net metering) to what they are currently paying (much less) and what they project to pay in the future (nothing).
In my analysis, I don't consider any income attributable to the system that is a result of the utility company paying for excess energy. That income stream is way too uncertain (IMO). So it isn't part of my analysis.
I know you know, Marion, how a DCF analysis works and can be applied, so the following isn't directed to you but may assist others who are not as familiar. Also, I'm open to any critique as what I do can always be improved upon. So sharing it allows me to hear those critiques.
A DCF models future cash flows, as they occur, and discounts them to a present value. The "PV" in this case stands for Present Value (rather than PV = Photo-Voltaic... it can get confusing).
Money "now" is worth more than money in the future. Therefore, the money in the future is "discounted" to reflect that relationship and get a current value.
Simply put, if I offer someone $1,000 now or $1,000 in 3 years, they'll take the money now.
If I offer someone $900 now or $1,000 in 3 years, they may take the money now.
If I offer someone $300 now or $1,000 in 3 years, they would (for this example) wait 3 years and collect the full $1,000.
In this example, the present value of $1,000 in 3 years is worth somewhere between $300 and $900. Lets assume that most people would be willing to take $700 now rather than $1,000 in 3 years. That's a discount rate of 12.5% (rounded).
Money "now" is worth more than money in the future. In the above example, $700 now is worth the same as $1,000 in 3 years; therefore. $701 "now" is worth more than $1,000 in 3 years (future).
That's the underlying premise in discounting future cash flows.
The inputs needed are:
1. Cash flows
3. Holding Period
2. Discount Rate
Holding this all together are assumptions (which should be stated in the analysis).
Cash flows as far as a Photo-Voltaic system (in my analysis) are not payments I receive from the utility company buying my excess energy but rather the money I am saving in my utility bill by having the Photo-Voltaic system. In other words, if I am saving $150/month in utility bills, that is the cash flow ($150/month x 12 = $1,800 annual savings). In this example, cash flow in year 1 is $1,800.
There are three things I consider in my analysis that can impact the cash flow over time:
The first is an assumption about changes in energy costs; I think a reasonable assumption is that energy costs will increase at least at the rate of inflation. Long-term inflation is 3%, so I would forecast my savings to increase annually by 3%.
The second assumption is that the system will degrade over time; in other words, as the system ages, its efficiency decreases thus saving me less over time. There are published material that provide, based on the age of a system, how it degrades over time. Knowing the age of the system here is important because the degradation isn't straight-line (however, for purposes of this example, I am using a 2% per year rate).
The third is maintenance costs. Again, there is published information regarding this, but we don't have to get too fancy. $100/year for maintenance reserve is not unreasonable.
So, in sum, my cash flows are based on how much money I am saving (not receiving as a payment from the utility company) on my utility bill, adjusted upward for an annual increase due to rising energy costs, adjusted downward due to the degradation of the system, and taking into consideration the maintenance costs (which also grows at the rate of inflation). The net is my annual cash flow.
Some may want to calculate the cost of removing the system and include that as a reserve (reducing cash flow by that amount); I don't but there is no reason why it couldn't be done (appraiser's choice, I say).
Holding Period for me is rather simple. The National Association of Home Builders publishes the average holding period of existing homes by (albeit broadly) geographic regions. There are additional research which gets more granular (regional, county, etc.). But let's use 8 years as the average for this example. Therefore, my holding period is going to be no more than 8 years. However, if the system itself has a remaining economic life shorter than 8 years, than that is going to be my holding period. Let's assume the system is relatively new, and has a total remaining life of 12 years. My holding period is 8.
Why is the holding period 8 years and not 12? Because my assumption is that a buyer "now" would be willing to pay something for a system that will reduce her utility expenses over her occupancy (holding) period, but it is too risky to forecast that the next buyer in 8 years is going to pay anything for a system that is near the end of its economic life. I think this assumption is reasonable.
Discount Rate data is one thing no one will find published for what we are doing. The way I handle this is by using the 30-year mortgage rate as my discount rate. My logic is this: If I am going to pay something additional for the Photo-Voltaic system, I could instead use that money to buy a higher-priced home (presumably having some other component that is worth as much to me as my energy savings). I don't get too fancy by adjusting the rate based on a LTV; I just use the stated rate.
The rate I see today is 4.125%, so that's my discount rate.
Using all of the inputs/assumptions above, the present value of the cash flows (savings on my utility bill after the identified expenses) is $12,311.
Now, what has really happened in the above? Is this how a typical market participant would evaluate how much the system is worth? No, it isn't. The only time I've ever had someone call me was when the borrower was an engineer; after he received a copy the report he said he used a similar process to value his system. He was the only one. So it is safe to say that the market participants do not use this type of analysis. But, that's the problem with this amenity; unless there are matched pairs, or unless there are sufficient instances where market participants (in the subject's market) are interviewed and the consensus is, "Oh yeah, this is worth $15k in the market all day, every day!", the DCF analysis becomes the (or one of) the next best substitutes to provide a contributory-value indication.
It certainly is logical and the assumptions (IMO) are reasonable. It measures precisely how the system would be valued
if all the assumptions were true and
if market participants used this analysis. But the last statement is true about any DCF analysis.
In my prior post, I said that I typically deal with valuing the amenity in the reconciliation. If the adjusted range were $600k to $625k, and without consideration to the system, I might conclude $615k. With consideration of the system, I'd reconcile to the upper range (most likely $625k) and I'm done.
That's how I do it. It isn't made up and has a logic and reasonableness of its own.
A couple of other items worth note:
A. It doesn't matter to me how much the system cost. That cost is a "sunk" cost. It could cost $500 or $50,000. All that matters is how much money is saved on the future utility expenses (without consideration of any utility excess-energy payments). A new buyer isn't going to subsidize the cost to install the system. A new buyer (rationally) will only pay more for the system based on what that system will save her over 8 years.
B. Earlier in the year, I was part of a large research project regarding energy efficiency components and residential homes. It took nearly a month-solid of my time. I am not at liberty to discuss those results, but what I can say is based on that research, which included detailed interviews with many agents transacting sales having such systems, the DCF analysis' value-indication I outline falls pretty well in-line with the value-indication ranges provided by those participants.
