The discounted cash flow method for property appraisals

Citation

French, N. (2012), "The discounted cash flow method for property appraisals", Journal of Property Investment & Finance, Vol. 30 No. 3. https://doi.org/10.1108/jpif.2012.11230caa.002

The discounted cash flow method for property appraisals

Article Type: Education Briefing From: Journal of Property Investment & Finance, Volume 30, Issue 3

Transparency, application and appropriateness

Introduction

In an earlier Education Briefing (French, 2006), it was shown that for the valuation of a rack rented freehold it is possible to undertake the valuation using either an implicit, all risk yield (ARY) model or an explicit discounted cash flow (DCF) method and the two methods will produce the same answer. They both utilise market expectations to produce market value.

In this briefing, the use of DCF is re-examined and developed in accordance with guidance provided by the Royal Institution of Chartered Surveyors (RICS) in the UK. The valuer has a choice of methods. Valuers undertaking the Income Approach of Valuation can use a simple implicit ARY model or they can use an explicit DCF model. Both are pricing models.

An explicit DCF valuation involves projecting estimated cash flows over an assumed holding period, plus an exit value at the end of that period, usually arrived at on a conventional ARY basis (exit yield). The cash flow is then discounted back to the present day at a discount rate that reflects the perceived level of risk. This method does the same as any valuation method, it is the process of determining market value. An estimation of the price of exchange in the market place.

When the explicit DCF is used as a valuation for market value, all assumptions must be market expectations. If the DCF method is used to calculate worth, then the assumptions are forecasts of the individual investor. This briefing is concerned only with valuation and not calculation of worth.

The use of DCF

In 2011, the RICS issued a standalone Guidance Note[1] entitled Discounted Cash Flow for Commercial Property Investments (RICS, 2011)[2] which promoted the increased use of explicit DCF for investment valuations. In the introduction of the Guidance Note, it said:

There remains a reticence within the real estate sector to adopting valuation approaches in which these factors are made more explicit. Nevertheless, since the price paid for an income-producing asset reflects the investor’s expectations as to its potential cash flows and risks, there is a strong argument that all assumptions should be made explicit, especially when investment decisions are being taken on behalf of third parties (Paragraph 1.4).

That is the crux of the explicit DCF method; transparency. If the only question is “what is the value?” Then an ARY technique is as good as any in estimating the price of the property in the market. However, in cases, where the investor want to understand the growth expectations (positive or negative) underlying the valuation, or understand the impact of the reversionary value at the end of the investment, then a DCF approach allows the valuer to provide that information.

It should be remembered that, as with any method, the explicit DCF method is just a technique of discounting; determining the present value of a cash flow. DCF is a method within the Income Approach.

The important point to remember is that if the explicit DCF is used as a valuation, then all assumptions must be market assumptions. If the explicit DCF approach is used to calculate worth (investment value), then the assumptions used are individual to that investor. The misconception about DCF is that it introduces new information; new forecasts. This is note the case.

Again the RICS Guidance Note says:

[…] it can also be used to estimate Market Value by adopting a set of tenable assumptions that are consistent with observed market prices, and then applying those assumptions, with appropriate adjustments, to the valuation of the subject property. Where there are no transactions, the explicit DCF model provides a rational framework for the estimation of Market Value not present in the ARY (capitalisation rate) approach, which relies on comparables for the identification of the ARY (Paragraph 1.5).

One of the main assumptions, contained in both the implicit ARY method and the DCF technique is expected growth. In a rising market, the use of the Initial Yield (derived from a comparable rack rented property) in the traditional method implies growth. This growth can be decanted out of the ARY by reference to the Target Rate[3] assumed in the DCF approach. This Target Rate will be derived form an analysis of the market players requirements.

In the aforementioned Education Briefing (French, 2006), a simple example was used where an investor accepted an initial return (k) of 8.00 percent, but required a Target Rate (e) of 10.75 percent.

There is a simple relationship between the Initial Yield (ARY) and the Target Rate:

Because of the UK rent review pattern[4], this relationship needs to be adjusted to allow the growth, when it happens, to “catch up” on the growth “missed” when the rent is fixed. The formula becomes:

This implied an annual growth requirement (g) of 3.2 percent. This has been calculated by reference to the following growth formula.

Calculation of annual growth

where:

k (8%) = Initial Yield (ARY)

e (10.75%) = Target Rate

ASF = Annual Sinking Fund at “e” for the market Rent Review period (rr)[5]

P =% growth over the market Rent Review period of five years

P = (0.1075−0.08)/0.1614

P =17.04%

Thus, the rental growth expectation over the rent review period is 17.04 percent, this can be expressed as an average annual growth rate by reference to the further formula:

Using this information, we can now look at the valuation of the following example (used in the previous Education Briefing and repeated here for ease of reference).

Example 1

• •

  Market Rent (MR) – £1,000,000 (per annum payable quarterly in advance)

• •

  Lease – 10 years

• •

  ARY – 8% (from market evidence)

• •

  Target Rate – 10.75 percent (Risk Free Rate 4.75 percent at that point in time (2012) plus 4 percent market risk plus 2 percent property/covenant risk)

• •

  Rent Reviews – 5 yearly

• •

  Annual Growth – 3.2%

Scenario 1 – rack rented

1. Implicit

• •

  MR – £1,000,000

• •

  YP perp @ 8.00% – 12.50

• •

  CV – £12,500,000

2. Explicit DCF (five year cash flows)

This model uses annual in arrears assumptions and groups the income into five year “chunks” which are valued using the Year’s Purchase (YP) formula for five years[6]. The use of the YP will present value each chunk of five annual cash flows back to the commencement of that cash flow. These are ten PVed again, as required, to bring all the cash flows back to year 0. It also assumes a sale at end of lease at an exit yield equivalent to today’s ARY (Table I).

Table I

In the DCF example above, the income column is explicitly grown at the implied growth rate of 3.2 percent, and then each five year cash flow is discounted at the Target Rate of 10.75 percent. At the sale in year 11, the capital value is calculated by assuming it will be sold at an exit yield of 8 percent. In the case of a rack rented freehold, the DCF method produces the same value as the implicit ARY method. As a pricing model, either can be used, however, the advantage of the DCF model is that it makes the assumptions underpinning the valuation explicit.

Interestingly, and as a result of the dominance of 25 year leases with five year reviews up until the 1990s, the majority of academic textbooks and papers utilise the format presented above. This is probably incongruous nowadays and an annual cash flow may be preferred.

3. Explicit DCF (annual cash flows – down the page)

This model uses annual in arrears assumptions and assumes a sale at end of lease at an exit yield equivalent to today’s ARY (Table II).

Table II

As can be seen, this produces the same capital value. Oddly, property values have had a tendency to produce cash flows that go down the page whilst other professions (bankers/accountants/actuaries) tend to go across the page. Again, this, obviously, produces the same answer but may be preferred as valuers work more closely with other professions. This is illustrated below.

4. Explicit DCF (annual cash flows – across the page)

This model uses annual in arrears assumptions and assumes a sale at end of lease at an exit yield equivalent to today’s ARY (Table III).

Table III

This certainly becomes the preferred style when quarterly in advance modelling is used and this will be illustrated and explained in the next Education Briefing in this series.

Notes

1. The DCF Guidance Note from the RICS was included in the 2011 edition of The RICS Valuation Standards (Red Book) but it has subsequently been announced that it will be removed from the 2012 edition and reinstated as a standalone Guidance Note.

2. The International Valuations Standards Council (IVSC) are also preparing a Technical Information Paper (TIP) on DCF l for publication in 2012. This will be discussed in a later Education Briefing.

3. In the past, the Target Rate may have been referred to as the “Equated Yield”. This is the same yield but non property professionals refer to the same as the Target Rate.

4. It is likely that the five year rent review pattern will eventually disappear in the UK but it is used for illustration here as it does still apply to larger prime properties.

5. See the Appendix for formulae.

6. The YP is the property term for the Present Value of £1 pa or PV of an annuity formula (the Appendix).

Nick FrenchDepartment of Real Estate and Construction, Oxford Brookes University,Oxford, UK

Appendix